A Comparative History of Bank Failures: From Medici to Barings 2019001662, 9780367191092, 9780429200489

Citation preview

A Comparative History of Bank Failures

Starting with Medici and Fugger and ending with Barings and Royal Bank of Scotland under neo-liberal de-regulation, the author gives an account of how a number of banks failed over a 500 year-period. The author offers an explanation of the leading ideas about the world and good society at the time, and summarizes this narrative using Streeck & Schmitter’s three bases for regulation of society: Community (spontaneous solidarity), State (hierarchical control), and Market (dispersed competition). The bank failures are presented in the context of social philosophies of the day (scholasticism, mercantilism, neo-liberalism, and libertarianism), and the changing business practices (Bills of Exchange, rents and financial instruments of various kinds). The dominating explanation of financial crises has been market-related. Here, the author argues that managerial failures are an important contributor. He demonstrates the failure of management to act on early signals such as existential risk, strategic stress syndrome, and lack of proper oversight by top management. The author encourages a return to ethical principles for banks, suggesting that his ethical aspect should be at the core of the credit process of banks in the future. With its interdisciplinary approach, this book will be an important contribution to the discussion surrounding bank failures. It will interest any scholar looking at the origins of financial crises and will be particularly useful for post-graduate students of economic and financial history, banking, finance and accounting. Sten Jönsson is professor emeritus in Business Administration (esp. Scandinavian Management) at Gothenburg University (appointed 1976), Sweden. His research has been focused on field studies of managers in action in various industries. Over the last few years he has led a research program on bank management.

Banking, Money and International Finance

Alternative Banking and Financial Crisis Edited by Olivier Butzbach and Kurt von Mettenheim Financial Innovation, Regulation and Crises in History Edited by Piet Clement, Harold James and Herman van der Wee Asian Imperial Banking History Edited by Hubert Bonin, Nuno Valério and Kazuhiko Yago Colonial and Imperial Banking History Edited by Hubert Bonin and Nuno Valério Financing California Real Estate Spanish Missions to Subprime Mortgages Lynne P. Doti History of Financial Institutions Essays on the History of European Finance, 1800–1950 Edited by Carmen Hofmann and Martin L. Müller Growth Without Inequality Reinventing Capitalism Henry K. H. Woo Austrian Economics, Money and Finance Thomas Mayer Price and Financial Stability Rethinking Financial Markets David Harrison A Comparative History of Bank Failures From Medici to Barings Sten Jönsson For more information about this the series, please visit www.routledge.com/ series/BMIF

A Comparative History of Bank Failures From Medici to Barings

Sten Jönsson

First published 2019 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 52 Vanderbilt Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2019 Sten Jönsson The right of Sten Jönsson to be identified as author of this work has been asserted by him in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Names: Jönsson, Sten A., 1940- author. Title: A comparative history of bank failures : from Medici to Barings / Sten Jönsson. Description: 1 Edition. | New York : Routledge, 2019. | Series: Banking, money and international finance | Includes bibliographical references and index. Identifiers: LCCN 2019001662| ISBN 9780367191092 (hardback) | ISBN 9780429200489 (eBook) Subjects: LCSH: Bank failures--History. | Banks and banking--History. Classification: LCC HG1561 .J66 2019 | DDC 332.109--dc23 LC record available at https://lccn.loc.gov/2019001662 ISBN: 978-0-367-19109-2 (hbk) ISBN: 978-0-429-20048-9 (ebk) Typeset in Bembo by Taylor & Francis Books

Contents

List of figures Preface 1

The problem with the role of banks 1:1 1:2 1:3 1:4 1:5 1:6

2

3

1

What this book is all about 1 A social science world view 2 The problem with banks 8 Plan of attack 12 Method 13 Analysis 16

Community as centre of authority: Banks are squeezed between the necessities of business, power politics, and the afterlife 2:1 2:2 2:3 2:4 2:5

vii ix

20

Religion 20 Finance 22 Divine Law and usury 23 Evolving practices – tricks of the trade 32 Three cases of bank failures in late Medieval Europe 35

Transition from regulation by State to regulation by Market 3:1 Transition 63 3:2 The history of economic analysis according to Schumpeter through to the Enlightenment 65 3:3 Mercantilism – the origins of political economy and, consequently, of economic policy 70 3:4 Industrial development – the outcome of economic policy application? 72 3:5 Case 4: Barings Bank 79

63

vi Contents 4

Market as ideology – toward the financial crisis of 2008

90

4:1 The need for economic policy production increases 90 4:2 “Epistemic communities” step in to set the agenda (neo-liberalism and libertarianism) 90 4:3 The roots of neo-liberalism 91 4:4 Libertarianism 109 4:5 Failed banks under de-regulation 118 5

Concluding remarks 5:1 5:2 5:3 5:4 5:5 5:6 Index

145

Summary with highlights 145 Commonalities and differences between victims of circumstances 153 The supportive role of the Community/State/Market triangle 156 Reflections on banks and their environments 160 Quo Vadis? Is there a next phase? 175 The problem with banks – again 184 189

Figures

1.1 Social orders according to Streeck & Schmitter (1985) 1.2 The path ahead 1.3 Foundationalism and Coherentism as formulations of justified beliefs 2.1 Community as a centre of authority 2.2 The social order centre of gravity moving from Community to State 3.1 Transition from regulation by “State” to regulation by “Market” 4.1 Market as “ideology” 5.1 Mercantilism pushed regulation from Community to State 5.2 The market did not save RBS and the Icelandic banks 5.3 Quo Vadis? – toward a new kind of Community

7 14 17 21 60 64 92 158 161 178

This page intentionally left blank

Preface

“Oh, you have a different opinion? How interesting! Let us discuss!” is a quote from an interview with another admirer of Jan Wallander who worked with him for many years. He used it to illustrate the attitude to subordinates (and to leadership) Jan Wallander held. In that spirit, hoping what I say might be worthy of discussion, even if it is based on weak evidence, I present this manuscript for discussion. Jan Wallander, the legendary CEO and, later, Chairman of the board, of Handelsbanken, was an accomplished scholar and a great leader of a bank that was pronounced the safest bank in the world several times (Cunningham 2017). Still, by not earning its money on taking undue risks, it performed better than competing banks in terms of return on equity for almost all of the years Wallander was in charge of the bank. The measurement of performance was important since the employees were engaged in a kind of a pension fund, Octogonen, by a profit-sharing arrangement initiated in the 1970s. The return on equity for Handelsbanken was compared with the average of the three other major banks in Sweden. If Handelsbanken was performing better the surplus over that average was split in two with one part going to the shareholders and one part to the pension fund. That pension fund was wise enough to invest in Handelsbanken shares – in fact it has been competing for being the largest shareholder in the bank for a long time now. And, as such, the employees are represented on the board. Yes, indeed! “How interesting! Let us discuss!”. An economist who collected his own data, he did field work for his thesis in the forestry areas of Sweden. The problem he considered was how the industrialization of logging affected the parts of the country where logging was a necessary complement to sustenance farming. That kind of research was rather rare in economics, and Jan Wallander, a very young doctoral student, travelled alone in the area to gather data. Later, when he had served as professor in economics at Stockholm University, and as director of an industrial research institute there, he was offered the position of CEO for a bank in the north of the country that was not doing too well. He took it as a challenge, against the advice of friends who saw a bright career for him in Stockholm. One of the things he needed to do then was to determine where the unacceptable credit losses had occurred. He told me – in an interview in the 1990s – that he found

x

Preface

that the credit losses came from decisions taken at headquarters, not from local decisions. The principle that all credit matters (also the largest ones) must be prepared and approved locally (at the branches), before being sent to headquarters for final approval, has been a strict one since then. This impresses a strong sense of personal responsibility on staff in the branches (and throughout the organization). You cannot say “Moody’s give this company a high credit rating” in the credit PM, you must say “I rate this company as creditworthy” and “I recommend that the credit be granted” (Moody’s credit rating being a piece of evidence, of course). So, loan impairment is low in this bank. Still, credit managers claim that only 30% of the quality of the credit process comes from initial decisions. The bulk of the work, and quality, is the periodical reviews of all credits – and at the time of the recent financial crisis there were monthly reviews of the whole credit portfolio, case by case. What kind of risk management is that? Haven’t they heard about portfolio theory, and value-atrisk simulations? Of course! They do those things at headquarters (and regionally as well), and there is a lively dialogue inside the bank, but that is not the most important part of credit policy. It has to do with personal responsibility! It is a matter of considering the relevant factors of each (local) case to arrive at better decisions. When I asked people in the bank about how come they have done so much better during the recent financial crises the answer regularly was “We have better customers!”. What? Where is that portfolio theory again? Today’s bank crashes do not happen by all depositors queuing up to withdraw their savings – a “bank run” as it were – but by other banks withdrawing their short-term funding of each other. So, I get the answer about policy on funding saying the “We want to be on the short list of partners when other banks start reducing the list of partners they do business with”. What does that mean? Well, for one thing, you cannot start work on improving your position on the other banks’ list when the crisis is already hot. You have to work on your reputation as a good (responsible) partner before that, in the normal, good times. Sorry about all this rambling about the peculiarities of one specific bank and its leader. Oh, let me add a further item: My last doctoral student, Caroline Teh (2017), studied the successful establishment of Handelsbanken operations in Great Britain over the last decades. It was an operation of setting up branches in a country with a very well established banking industry – a mature market. Two things; one branch manager told Caroline about how she was recruited by being asked to propose a plan for how she would go about establishing a new branch in a particular urban area. She went home and made a plan, was asked questions when she presented it, went home again, and then was told: “OK, go ahead!” Then I realised, she said, that is was my plan – personal responsibility again. Caroline was often met by statements like “At last I am allowed to do real banking again!” The branch managers were usually quite experienced bank managers from British banks. Now they were back in business, and they were warm fans of Jan Wallander’s principles. In sum, this bank is different from other banks we have studied from the inside, and the difference seems to stem from the particular acts of leadership

Preface

xi

that bank leaders have carried out. Game changing principles have been implanted in specific situations and remained in that particular bank because they have been proven successful. There may be merit in trying to study individual banks in particular contexts! I came into the business of studying banks as organizations, late in my academic life by, not coincidence, as much as by a Wallander initiative. One evening in 2007 I got a phone call from Jan Wallander. We knew each other from the 1992 interview and since I had been a member of the academic group of researchers that prepared reviews of research applications for the Handelsbanken Research Foundation for many years. Still I was surprised! He said: “Why don’t you start a research program on banks that can be of interest to real banks” (Finance theory studies by economists had dominated the agenda for many years.). I was flattered for being asked, of course, but I saw no way to do this. I was only a couple of months away from retirement. My response was “I cannot start something new now! I am too old! I am 67!” ….. “and I am 87!” he said. So much for the age argument! I knew he was still active, appearing before the board with sharp analyses of bank management issues. So, I applied for a grant and got it, assembled a research group and started to investigate banks in Sweden, with the excellent access researchers have to companies in this country. The problem with studying the practices of particular banks in particular contexts is that it is quite difficult to publish articles on the results in established scientific journals, who desire generally applicable results with the statistical evidence to back them up. So, after 10 years of field and library work I came up with the manuscript before you as a kind of final statement of banks and their failures. When you are searching for lessons to learn, it is only natural to search for success and try to pinpoint the factors that most contributed to that result. I have gone the other way – searching failures and for principles on what to avoid. It started with a review of the work of Odd Langholm of the Norwegian School of Economics, who have specialized in Aristotelian economic ideas and scholasticism (on usury). I thought it was about time that management scholars in Scandinavia recognized the extraordinary contributions on early economic thinking that Odd Langholm has done. I sent an article manuscript for review to a Scandinavian journal. The reviewers complained that they could not see what this had to do with the current theoretical development and wanted me to connect it to the current literature on finance theory. I refused, saying that this is not about current theory but about pre-theoretical reasoning on fair price and usury almost a thousand years ago. The response was that in that case they were not interested. Fair enough! I had become interested in banking without theories of finance and soon came across the cases of the Medici bank in Florence and the Fuggerbank in Augsburg. Economic historians have interesting, and well documented stories to tell. One can add conclusions to their material by applying basic managerial ideas. Following the fate of the Fugger bank when it followed the Habsburgs to Spain, and the account for the development of later scholasticism in the School

xii Preface of Salamanca it was very exciting to discover the failure of the banks in Seville. The cause was according to one source that too much money flowed into Seville from El Dorado – the newly discovered Latin America (shiploads, whole fleets, of gold and silver). What? Banks going bankrupt because of too much money? Here I ran into trouble because there was much source material in Latin and Spanish, so I contacted my old friend Salvador Carmona for help. He has done many interesting studies of management and accounting on historical material. They do have very extensive archives in Spain from the time when Spain was the centre of the world (and money)! Salvador was very helpful and engaged in reading draft versions and give valuable advice. I asked him if he would want to become a co-author but he declined and continued to encourage and advice, for which I am truly grateful. The Fugger bank made the strategic mistake to let itself be too closely tied to the Habsburg dynasty (Austria, Spain, Netherlands), which gave me an occasion to see how action (banking) moved to Holland and then London as colonies were exploited (by state-privileged companies like the East India Company or South Sea Company), state capabilities were built and wars determined who would rule the waves. State administrations became strong and well enough organized to regulate and manage financial flows across borders. The set of ideas about national management of money flows that took hold is called Mercantilism Special circumstances, and good government, led to the impressive investment in manufacturing in Britain and the definite move of merchant banks to London. I have chosen Barings Bank as an example from the Golden Days of merchant banking in the 19th century. As we know Baring Bank failed early on in what developed into the recent financial crisis. It failed partly because of “strategic stress” with too many options to choose from and too little capital to carry some of them out, but primarily because of internal, undetected fraud (Leeson). There were similarities with the speculative activities and accounting fraud of Sassetti in the Medici bank 500 years earlier (Soll 2014)! To illustrate the failure of banks in the recent financial crisis I have chosen the Royal Bank of Scotland (RBS) and the Icelandic banks. There were many alternatives, but the RBS has a “piquant” connection to Spain and Italy in the alliance between three banks that tried (and in a sense succeeded) in taking over the AMRO ABN bank. As for the Icelandic banks one of the first analyses of the reasons for their failure I read pointed out that too much money had flowed into the nation to generate an untenable credit expansion – just like the banks in Seville 500 years earlier. The background to that financial crises is, in my view, neo-liberalism and libertarianism, which pushed governments into too fast de-regulation, which in turn constituted strategic problems for most banks, problems that they did not have the managerial capacity to master. Together these cases will generate a historical material of failures in context that will, hopefully, stimulate readers to discuss and study further. I am fully aware of weaknesses in the evidence and I have relied on secondary sources, sometimes against the advice of fellow researchers. At best, there is some “circumstantial” evidence on the connection between ideas/philosophies of the

Preface

xiii

nature of the good society at the time, and the practices of the banks leading up to failure. The discussion of what we can learn from these cases in their context must be just that – a discussion. For students, that discussion may lead to an interest in the history of banking, and the rich sources for further study that many countries have. For researchers the short look across the fence to economic history may encourage a dialogue between disciplines on common problems that are discouraged in many ways by the stultifying measure of performance measures (in terms of number of articles in the right discipline ranked journals) of today’s university scholars. I thank the members of the Bank Management program of the GRI for their encouragement, critique and patience with my disappearance from joint work at times. Airi Rovio – Johansson, Gudrun Baldvinsdottir, Gunnar Wahlström, Roy Liff, and Mikael Wickelgren have read lots of unfinished texts with patience and engagement. Thank you! Asgeir Torfason and Caroline Teh have written price-winning PhD theses in banking during the time of the program, which we are proud of. The large part of the budget of the Bank Management program has come from grants by the Handelsbanken Research Foundation. Thank you. GRI (Gothenburg Research Institute), a multidisciplinary research institute, has provided space and a home for our efforts, which is much appreciated. It has been a frustrating job to write this manuscript with all its gaps and overlaps, but here it is. I humbly submit to the judgement of the reader awaiting the sentence as to whether it was worth it. Sten Jönsson Göteborg Summer of 2018

References Cunningham, Andrew (2017) World’s Safest Bank. Global Finance, September 11. Soll, Jacob (2014) The Reckoning: Financial Accountability and the Rise and Fall of Nations. New York, NY: Basic Books. Teh, Caroline (2017) Re-searching Stewardship. PhD thesis at Gothenburg University. Göteborg: BAS.

This page intentionally left blank

1

The problem with the role of banks

1:1 What this book is all about Banks are different from other organizations in that they are particularly dependent on the goodwill and trust of their customers. Their business is to “translate” money between places, over time, and from short to long term. This means that they are particularly sensitive to context, be it business or norms of proper conduct. I try to illustrate this by three bank failures in the context of war, emerging State administrations and scholasticism from about 500 years ago, and three cases from current times in the context of deregulation, financial crisis, neoliberalism and libertarianism. In the period between these failures the ideas of market price (“common estimate”), money supply, and enlightenment (science) set the stage for new approaches in the study of wealth and money. Mercantilism, promoted by pamphleteers, required a State bureaucracy to control and manage money flows. In modern times we wonder about the meaning of “bit-coin” and “flash-crashes”. Negative interest rate? What does that imply? The less money you have the better? The book starts in Hell. That is where those who charge interest spend their afterlife. Dante told us that it is deep down in the lower parts, on smouldering hot sands. The Church Fathers and scholastics (mostly in Paris) were inspired by Aristotle, who built his views about fair price on the Free Will. Contracts are only valid if they have been entered into of free will by both parties. There was no conception of a market price. Langholm (1984) shows that the arguments of the scholastics only make sense under a no growth assumption. Without investment opportunities the interest is zero (as they are in equilibrium). A second version of scholasticism emerged in the texts by the “Doctors of Salamanca” (late 1500s) as they tried to explain why Spain was in decline in spite of the fact that treasure (silver and gold) flowed in to Sevilla by shiploads from “El Dorado” (America). The money supply is mentioned for the first time 200 years before it became fashion in Britain. Mercantilism and a managerial State monitoring the flows (and extracting taxes) was the solution. I show how the Medici Bank crumbled because top management stopped paying attention to double entry book-keeping (which Cosimo, who built it

2

The problem with the role of banks

all, had done) and was defrauded by branch managers, and also how Pedro de Morga went bankrupt in Seville in the second half of the 16th century as the King resorted to “forced loans” and seizure of cargos (against IOUs) to finance his wars. He also stopped servicing the Crown’s outstanding loans several times. Pedro de Morga had made himself too dependent on the “court banks” commentators said. One such “court bank” focusing on one customer, the Crown, was the Fugger Bank of Augsburg that, in a roundabout way, had attached itself to the Habsburg royalties and stayed loyal with the Catholic side to the bitter end of the 30-years’ war (17th century). The 19th century, the Golden Age of merchant banks, saw Barings Bank prosper (always second after Rothschild). The action had moved to London and Barings served American customers in London. It managed through the wars, but met strategic problems with the Big Bang – how to acquire the necessary set of competencies for a complete portfolio of services when equity is tightly held by family. They chose to recruit a team of traders in Far East securities and got Leeson in the bargain. Like Medici, Barings was unable to discover internal fraud and the bank failed. Royal Bank of Scotland failed on the basis of hubris as its leaders thought they could do no wrong, and entered into a deal the premises of which were no longer valid. The Icelandic banks failed because two of them thought they had found a new way of funding the banks by deposits (!) when the credit market pulled the brakes. In the three recent cases, the background social philosophy was neo-liberalism and to some extent libertarianism. These ideas stem from the debate in Vienna over how to design a new (German-speaking) State after the defeat of the Double Monarchy in the First World War. Activist economists, inspired by the Austrian school represented by, primarily, Friedrich von Hayek, legitimized a practice of giving policy advice promoting liberty, market solution, and monetary activism. Libertarianism, backed by big business, went a step further and invested in lobby institutes and the training of anti-big-government activists. And here we are in 2018 with cyber-wars, super-fast transfer of capital across the globe, authoritarian governments, and a general democratic confusion. What next?

1:2 A social science world view This chapter is inspired by Josef Schumpeter (1954), Deirdre McCloskey (2006, 2010, 2016), and Wolfgang Streeck & Philip Schmitter (1985). By Schumpeter because he dared to apply quite a wide set of perspectives on the development of ideas in his majestic book History of Economic Analysis. 1 One indicator of this book’s greatness is the fact that reviewers of the book, almost to a man (no women mentioned) judged the book brilliant, even if they had some severe points of criticism – see Perleman’s Introduction to a later edition that he starts with a quote from one of the reviews:

The problem with the role of banks

3

There is, as we shall see, much in this book which is redundant, irrelevant, cryptic, strongly biased, paradoxical, or otherwise unhelpful or even harmful to understanding. When all this is set aside, there still remains enough to constitute, by a wide margin, the most constructive, the most original, the most learned, and the most brilliant contribution to the history of the analytical phases of our discipline which has ever been made. (Viner 1954, pp. 894–5) One frequent complaint among reviewers was that Schumpeter did not pay enough respect to US and British contributions. Perleman mentions that Schumpeter considered Adam Smith “a small potato” in the general flow of theoretical ideas. Grice-Hutchinson (2015) makes a similar argument by pointing out that the first five chapters of his Wealth of Nations is a repetition of texts from the School of Salamanca more than 200 years earlier. So, a somewhat “wider perspective” might be in order after all, even if many of the faults Viner mentions necessarily follow from the adoption of Schumpeter’s manner of perspective. The inspiration is, as it were, in a Nietzschean way, to trace concepts and conceptions back to, if not their origins, to earlier articulations in different contexts. It is self-evident, is it not, that all theoretical statements are articulated in a particular context with a particular code of conduct and particular problems. Only mathematical and logical statements can be said to be context free (even if most of them are surrounded by assumptions about the nature of the variables under consideration (continuous, random walk, normal distribution, etc.)). Schumpeter (1954), thus, maintains that we should pay attention to those particular contexts in which all theoretical ideas are articulated. He also argues that progress was often made when scholars tried to sort out new problematic situations – he even has a chapter on “Consultant Administrators and Pamphleteers”, i.e., when scholars and wise practitioners argue diagnostics as well as therapeutics for an ailing economy. One cannot help getting the impression that Adam Smith, who valued his Theory of Moral Sentiments (1759) higher as a scholarly work, looked upon Wealth of Nations (1776) more like a pamphlet – arguing the case for a certain policy (Otteson 2002), by compiling existing “academic” arguments to a well written and convincing text. This close interaction between scholarly work and practices of old seems to have been lost in some quarters nowadays – or has it? The libertarian tactic of sending out messengers from George Mason University (or other think tanks) to nearby Washington, with the purpose of influencing policy as well as appointments in the judiciary, is an indirect way of pamphleteering that should not be ignored. The context in which diagnostics and therapeutics are discussed today is quite different from those old days. Still we can learn from the arguments presented then. One thing that is different is that large organizations are managed with a much higher debt than was usual at the time when most of our theoretical underpinnings for judging business practices were developed (for example Austrian

4

The problem with the role of banks

economics). This – debt – puts banks in a more central role in the economy than at any time before. They used to be family businesses with few employees and remained so through the Golden Era of merchant banks in the 19th century, up to today’s global, enormous organizations with huge sums of money at their disposal (mostly “other people’s money”) that can be transferred to any part of the world in a split second – no longer any need for “Bills of Exchange” to be transported by ship for 90 days between Antwerp and Genoa! Now, perhaps, more attention to credit management is needed, and less to return on equity. Banks are chiefly funded by credit from other banks. Bank runs in their classical form do not happen anymore. The financial sector now generates a large part of the GNP in advanced countries, mostly by trading in financial papers (promises that if X happens, I will pay the bearer Y) – a form of gambling outsiders might say (MacKenzie 2006; Mackenzie & Spears 2014), but advanced science – according to insiders with Black & Scholes (1973) to prove it. That proof is built on the assumption that prices of options move randomly (random walk), and the mathematics used was intended for calculations of the movement of molecules in gases. We should be, and we are, impressed by scientific progress in new areas! Deirdre McCloskey (2006, 2010, 2016) works in the same spirit as Schumpeter, conscious of the unavoidable influence of the context on academic as well as on other work. She claims that economics cannot explain the extraordinary economic growth in the 19th century, some of it, yes, but most of it, no. There was a “hockey-stick” effect of very rapid growth then, and – she claims – it was bourgeois ideas, virtues as well as a sense of equality, not capital or institutions, that explain it. The bourgeoisie believed that man can form his/her own destiny through entrepreneurship and diligence. You are no longer “born” into your station in society. It is ideas rather than capital; dialogue, debate, maybe even “language games” (in communities) that form our conception of what is possible and proper. For an economist from Chicago like McCloskey that is pretty unorthodox. New perspectives open up – there are a number of explanatory hypotheses that have not been tested yet, simply because we do not know how to measure certain phenomena. Cooren (2010) places passion at centre stage in action (speech is also action) and argues that there is a gap between rationality and action – the courage to take the plunge – to risk making a fool of oneself – by going into action on the basis of this incomplete information. That gap is bridged by passion. Here the age-old virtues come in, since that passionate step needs to be taken on moral grounds. McCloskey (2006) lists seven virtues (Love, Hope, Faith, Justice, Courage, Prudence and Temperance). The first three are the “warm” ones stemming from Christianity, while the four others are “cold” calculating, deliberating ones coming from the Enlightenment and the Ancient Greeks. When the bourgeoisie found their dignity, and considered themselves equal to the hereditary aristocracy that had dominated everything on account of their land ownership, they applied entrepreneurship to the host of ideas from science and engineering that could be exploited for the good of a growing number of customers. It may have been these ideas that fired the passion for business with

The problem with the role of banks

5

inventors at work on every corner of society. Those inventors must have thought a lot about how to get their product to market, even if the inventing was their core activity. Banks must have received lots and lots of proposals – merchant banks – and large volumes of goods were flowing in from overseas! Both Schumpeter (1954) and McCloskey (2006, 2010, 2016) are scholars that take a historical perspective to find the “origins” of some of our theoretical shortcomings. They both stress the development of ideas in a dialogue between “theory” and “practices”. I bring with me from them the significance of ideas in crises, and cannot help recognizing support for this view in Milton Friedman: Only a crisis – actual or perceived – produces real change. When the crisis occurs, the action taken depends on the ideas that are lying around. (Friedman 1982, preface ) With all those ideas lying around, individuals and organizations, like banks, need some tools to help them structure and orient themselves, in order to stabilize a changing world. (I will call those tools principles.) The logics that these principles generate when applied in context are called social orders, and serve to regulate proper conduct. Rules, norms, habits – there are many conceptions of these tools of judgement. Rhetoric is required when you need to persuade others of the merits of your new idea. Applying principles means following rules. Streeck & Schmitter (1985) have developed a three-pronged conception of social orders, sometimes called corporatism. We live by rules, not least in language (Wittgenstein 1953), and there are different approaches to rule-making that will constitute social orders. They are always present when society is framed and re-framed – note the Friedman quote above – but one of them can usually be seen as dominating – crises may shift the balance. The individual in such entangled social orders will have difficulties to cope with the overflow of principles – which ones are the appropriate ones to apply to this particular situation? One can only refer to Merton’s (1968) “strain theory” which tell us that in situations characterized by “complexity and contradiction” there is an increased demand for ideology, i.e., guidance as to what values/principles are relevant in constructing action. My pre-conception is that the sources of such guidance (ideology production) varies over the centuries, with dominance for religion over a very long period up to around 1600, and the social order that this generated fits the Community type given by Streeck & Schmitter (1985). Community (spontaneous solidarity) represents an approach where good arguments carry the day. Learned people (professionals) are able to interpret situations and apply the appropriate general rules to the particular case – like doctors do when they diagnose the patient and recommend the most suitable therapy considering all relevant circumstances. The priest, rabbi, or imam gives the individuals good advice as to how to live their life, based on the interpretation of sacred texts. The coach indoctrinates the football team to play in accordance with a particular system to win an important match. The desire to maintain membership asserts a disciplining power. Rules become normative at

6

The problem with the role of banks

the same time as they are instrumental. The authority of community regulation comes from knowledge and experience – and membership. The common good is at the centre of all judgement. Market (dispersed competition) solves problems by competition. Actors, who want to improve their lot, offer solutions that other actors approve or disapprove of by their willingness to pay. Entrepreneurship and exchange pushes processes toward equilibria where no actor sees opportunities for further improvement. Contracting requires that the free will of participants is not tampered with, not by the State or by manipulation of the free market. All actors will benefit if competition is kept free from impingements on the free will of everyone. The development towards social improvement is Darwinian in the sense that inferior ways are eliminated by the sequence variety, selection, retention. State (hierarchical control) represents the rule of law and equal treatment under those laws to ensure justice. Hierarchical promotion is based on merit, which assures the authority to promulgate new rules at the top. Decision-making must follow proper procedure. There will be hierarchies within hierarchy. Whether the top (the Sovereign, or the Principal) is obliged to follow its own rules is a problem discussed as early as 1651 by Thomas Hobbes. The State logic celebrates rationality, planning and equality. The common good is the main argument in rule making, but maintenance of power/authority at the top is also essential. As mentioned, all these forms of social order logic are present all the time. Which one dominates or is judged most adequate depends on context (and what ideas are lying around at the time, as Friedman said), but there seem to be fragments of all three forms engaged in most forms of social order. The emphasis varies over time. My working hypothesis is that in order to understand regulative processes one has to map them in context. Such a context may be material conditions and/or ideational ones. If religious ideas (or socialist ones) are gaining adherents this may influence the path practice processes take and their results. If a strong and well-organized State is present, its organs will be engaged. If market processes are under pressure (taxation?) arguments to push back State influence will be generated. Communities may organize (“special interests”) to influence rule-making by the State, but they may also organize market imperfections (like cartels), or sow division within the communities themselves. Akerlof & Shiller (2015) remind us that, if there are opportunities to gain by breaking rules, people are likely to do just that. Boltanski (2009) provides a vocabulary for understanding inherent problems in hierarchies (worthy of critique) in reminding us that, in the hierarchy of State, members who are good at circumventing rules, or “bending” them, as it were, are the ones that tend to get promoted. They win approval by “getting things done”. But if they continue to “cut corners” and bend rules when they have reached the top, that very behaviour will be seen by members, which, in turn, will undermine the authority of the hierarchy (“thresholds of tolerance” (Boltanski 2009, p. 67)). This will invite justified critique (or engender corruption). That kind of behaviour just described is, obviously, ruinous to Community as well as State as a generator of social order. One may only hope that the

The problem with the role of banks

7

pleasure of being a member contributing to some shared goods will be greater than the pain of being a non-member (outcast). Klamer (2017) discusses the human activity of “valorization” and pleasures of participation in consumption of shared goods, like friendship and a shared meal with interesting conversation. Such enjoyment happens and may be a worthy end in Community (and in other social orders too). Friendship is “shared”, and it grows by members’ contributions to the enjoyment of being friends. They “valorize” the group membership. The difference between a “house” and a “home” is due to the valorization done by the people who live there. (I will claim in conclusion that the proper task of banks is to participate in the valorization of their clients.) There are good reasons to assume, I will maintain, that a given social order, as a basis for regulation of proper conduct, is unstable, partly because of changes in context (like an industrial revolution), partly because of the inherent contradictions in practices under such an order. We need to pay attention to outer cycles of “worth” as well as inherent contradictions in evolving practices, when we discuss problems and their solutions over time The theory/debate cycle will send “principles” into this space of sense making about what is important and appropriate here and now, pointing out what (according to “theory”) ought to be applied. In the other direction, out of the experiences of practices, flow principles that seem to work well (or

STATE “Hierarchical Control”

“Theory/Debate” / Principles “Theory/Debate”

Practices Principles

MARKET “Dispersed competition”

COMMUNITY “Spontaneous Solidarity”

Figure 1.1 Social orders according to Streeck & Schmitter (1985) Note: This is the master figure I will use throughout the text to portray the context in which the specific banks failed.

8

The problem with the role of banks

should not be applied because they do not work here), and, thus, are in need of theoretical articulation. Some of these principles are retained as organizational principles in a particular bank/practice, and configured into “business models” (for lack of a better phrase). Members of such an organization will be given a role in organizational work related to this business model. Membership work, the activity aiming at confirming membership, will include acting in alignment with the duties implied by the business model. Such work will also include the requirement that the activities are effective in achieving desired ends. In this way “business models” (consisting of principles) serve as sorting devices as to relevance and significance of received signals (or discerned phenomena), construction devices in the design of appropriate action, judgmental devices in recognition of commendable action. They frame the individual’s identity. Korsgaard (1996) argues that the normative power of reasons (based in the principles of the business models) comes from our will to live up to our identity. Business models, thus, will help members to orient themselves in a changing world, and discern what is relevant, what is problematic (in need of solution or at least to be reported to the boss), and what is good (we should do more of that!). Organizations will have more or less articulated, shared (or at least overlapping), business models. These interpretive grids consist of gestalts of principles that members are assumed to adhere to. Identity building means to establish your role in the organization by acting accordingly. (I am the Human Resource Manager and I work to fulfil my organizational duties.) I hope that by watching out for the business models in use in the case studies I will be able to discern clues as to what went wrong when a bank failed. This could be a help in learning how banks work in different circumstances and what did not work in that particular situation. Focusing on the banks themselves in their contexts rather than aggregate phenomena on the “system” level might be helpful. It should at least be tried. Having given a sketch of the world view of what contexts banks are active in, it is only proper to give an account of what the problem seems to be.

1:3 The problem with banks Not so long ago the world experienced a financial crisis with devastating consequences, which has been commented on and debated by many. So: a huge unregulated boom in which almost all the upside went directly into private hands, followed by a gigantic bust in which the losses were socialised. That is literally nobody’s idea of how the financial system is supposed to work. It is just as much an abomination to the free marketeer as it is to the social democrat or outright leftist. But the models and alternatives don’t seem to be forthcoming: there is an ideological and theoretical vacuum where the challenge from the left used to be. Capitalism no longer has a global antagonist, just at the moment when it has never needed one more – if only to clarify thinking and values, and to provide

The problem with the role of banks

9

the chorus of jeering and Schadenfreude which at this moment is deeply appropriate. I would be providing it myself if I weren’t so frightened. (Lanchester 2008, p.5) Kindleberger (1989) gave us a sense of the mechanisms at work, with the manias, panics and crashes, particularly giving detailed accounts of the Mississippi and South Sea bubbles. Reinhart & Rogoff (2009) pointed out, in the very first pages of their book, when explaining why they had chosen the title This Time it is Different for their book on Eight Centuries of Financial Folly, that there are indeed psychological processes involved. They acknowledge the help with the title of their book provided by Vincent Reinhart, who worked for a long time for the Federal Reserve and told them about a meeting at the Federal Reserve between the board of governors and practitioners to discuss the collapse of the Long-Term Capital Management hedge fund. One seasoned trader explained, “More money has been lost because of four words than at the point of a gun. Those words are ‘This time it is different’” (Reinhart & Rogoff 2009, Acknowledgements). The mechanism illustrated by those four words is our tendency (before the crisis?) to seek out evidence that stabilize expectations and assure us that things are not as bad as some people fear. Reinhart & Rogoff (2009), further, argue that most analyses of financial crises have been “essentially narrative” (p. xxvii) and that they themselves have undertaken to compile all data they could lay their hands on and provide analyses in the form of tables and diagrams. They treat sovereign debt crises and bank crises separately (even if they seem to be intertwined very often). Concerning bank crises there is much less data to capture, especially from the old days when most banks were privately held (Medici being a good exception with de Roover’s study (1963), albeit his getting access 500 years later). Bank crises come in two forms, Reinhart & Rogoff (2009) claim, as bank runs (depositors taking out their money), or as a result of financial stress following from events, like large-scale government intervention to “save” an important financial institution. They also note that, while some countries have managed to learn from experience of sovereign debt crises and come out (“graduate”) with better managed finances, there is scant evidence of such learning effects for bank crises (p. 153). One can only speculate why this is the case. One obvious explanation is that failing banks cease to exist and what learning did occur at best was carried into other employment by the individuals who leave the sunken ship. But those lessons would not be very attractive, since the messenger came from a failure. Another possibility is that banks, since they are keen observers of each other, might observe things in other banks that they should avoid; however, it seems they do not. One bank CEO that I interviewed explained that in normal times it is easy to keep revenue higher than cost. The only difficulty is when credit losses escalate, my respondent said. The problem here is that such credit crises in this country only come every 15–20 years. By then the people who experienced the last crisis have moved on to

10

The problem with the role of banks

other positions or have retired. The organization cannot learn from experience with such long lags. (“Banking is boring”, a Spanish CEO told a colleague, “it is when you try to make it more fun that risks grow!”). Again, we might conclude that there are good reasons to warn against the use of the expression “This time it is different!” also in the individual bank. So, what does it take to learn from other banks’ failures? Was it really that “different” when banks failed 500 years ago? Banking seems to be more dependent on how its customers perform than many other industries. Banks need to watch every move the customer makes to judge the effects on the creditworthiness of that customer. In modern days, when there are financial instruments and secondary markets to keep the performance of customers at arms-length distance other problems emerge, like volatility. But volatility can be handled by the use of scientific portfolio theory, can’t it? Before 2008 most practitioners believed it could – some of those were bankers who admitted that they did not understand how those formula worked (Mackenzie & Spears 2014). Such admissions, at that time, would have run the risk of being “classified” as old-fashioned. Reinhart & Rogoff (2009) remind us that banks are indeed different from many other industries by the fact that “loans” appear on the asset side of the balance sheet. The emerging crisis appears in the form of deterioration of the asset side. But with more than 95 % of the balance sheet consisting of debt, and with most of the lenders being other banks, banks are vulnerable to withdrawal of credits. When the crisis is imminent, other banks will review their commitments and cancel short term funding to fellow banks. These fellow banks will find themselves short of cash and in need of quick action, which will in a very short time spread the crisis throughout the financial system. However, that initial deterioration, even if it is significant, will not show up in financial reports of the banks until it is too late – up to a year later, when official financial reports are submitted. Action will have to be based on inside/soft information, even rumours. When such a modern “run” on a bank with a deteriorating asset side happens, it will happen fast.. It has always been very important for banks to maintain their “good name” since so much of banking is run on trust, but when the “good name” is lost things happen faster in the modern world with its IT-based mobility of huge financial assets. It is too late to try to repair the “good name” when it does happen.. This kind of argument gives reason to assume that the failure of banks in ancient times happened, as it were, in slow motion, and managers could be expected to have more time for action. Maybe one could learn something from what went wrong then and compare with modern cases of failure? This is an important question since banks are so central to the building of national wealth. Soll (2014) has provided a lively exposé of how important proper accounting and central leadership were when effective State administrations were built. Profit-oriented studies (economics as well as accounting) tend to focus on equity (and return on equity), while one soon realizes that debt is the major source of finance now, and banks are involved, one way or

The problem with the role of banks

11

another, in judging creditworthiness. They play a central role, as Adam Smith (1776) stated. We should try our best to find clues as to what can help banks learn from experience (their own and that of others). Supervision by professional agencies (public or private) is required,2 obviously. But the key is the conduct of business by the banks themselves, translated into their business model, articulated in principles they live by, and used to identify roles of members, to discern relevant aspects of the context in which they operate, and to construct appropriate action. I am interested, then, in the attention banks pay to changes in their environment, and how they use information on those changes to adapt and, at times, take initiatives intended to counteract those changes (or make good business out of them). Focus is on business models as mediators for banks under varying conditions and over time. As mentioned, a feature that has gained attention over the last few decades, is modelling stemming from econometrics. With modelling, assets can be valued based on expectations about future business conditions. Economists have long despised accounting’s backward-looking valuation rules (historical cost – something is worth what it was acquired for until any increase in value has been realized through sale) and over the period of de-regulation of the financial sector also managed to persuade rule-makers to adopt “market prices” as the main method of valuation. That is all right so long as there is a market price. In crises, many financial markets “freeze” and then, say the new rules, you can use “models” to justify valuations. The problem with that is that a bank in trouble will over-value assets (hoping for things to turn for the better) because the lack of relevant (crisis) data makes it possible to manipulate values (which you cannot do with historical cost). This problem with modelling in crises does not only occur in the banks. It is also notoriously difficult to forecast the economic development of any nation in the wake of a financial crisis. Ahir & Loungani (2014) showed that of the 62 recessions (GDP declines over two consecutive quarters) that occurred in many countries after the 2008 crisis, none was predicted in the Fall of the year before by national forecasting institutes. We all know Milton Friedman’s argument that the only valid test of a theory is its ability to predict (“positive economics”). Prediction of turning points is not the strong point of positive economics. The old statistical distributions cannot be relied on any more. We have to look further than “positive economics” to find clues for how banks could become more adept at coping with changing contexts and new phenomena (like Bills of Exchange or sub-prime loan tranches). So, this is the, admittedly vague, starting conception for this study. 1

2

I borrow from McCloskey (2006, 2010, 2016) that ideas matter. When people have absorbed virtues, a sense of dignity and equality, they may take action in order to achieve new things (and economic growth). I borrow from Schumpeter the claim that theoretical (analytical) economics develops in interaction with the practical issues of the day. (If an economic idea gives rise to a new kind of regulation, practical people will immediately

12

3

4

The problem with the role of banks start working out ways to circumvent the rule, which in turn gives rise to new analytical work.) Theory and practice are thus entangled in continuous interaction. Causes of change can come from both quarters. I borrow from Streeck & Schmitter (1985) the idea that social orders may differ in terms of their basic logic (Market, State, Community). The social order dominating at the time sets the stage for what constitutes valid arguments and what principles are accepted as appropriate. Debate as well as crises may shift the centre of gravity among the three logics. “Schools of thought” articulate core issues on a societal level, and world views change. The principles that an organization sanctions as its business model – principles that denote commendable action and define organizational roles – become the tools for sorting confusing crisis information, judging validity of arguments, and building a platform for action in crisis.

This is the context in which banks have to find their way.

1:4 Plan of attack The problem of banks succumbing to the temptations of mania, or linking their business to powerful rulers, or betting on the wrong side in a war, must be illuminated by a choice of cases that exhibit variety in context. The cases need to be fairly closely described in order for business models to be visible. The same goes for context, which needs to be described in terms of business practices as well as ideational debate. In order to avoid the one-sidedness that stems from current views on regulation/de-regulation I need to seek out historical cases, albeit more turbulent in many ways than the present circumstances, but also formative in the sense that international trade was developing as well as new views on science and the dignity of the individual. The desired case study in context will contain three moments; a description of the ideas in use at the time (determines what arguments are valid), a description of business practices (determines the need for financing and investment), and the activities of the bank in question (its business model in action). This is, of cause, a tall order, when it comes to historical cases. One has to rely on economic history, where authors may be interested in quite other aspects than business models. 



I have chosen the Medici bank of Florence because it is well described by de Roover (1963) and by Soll (2014), and embedded in scholastic doctrine, while Italy was the centre of international trade and banking up to Spain’s exploitation of the newly discovered Americas from the beginning of the 16th century. I have chosen the Fugger bank of Augsburg because it seems to have been the richest bank in Europe with much of its business tied to the Habsburg dynasty ruling in Vienna as well as Spain and the Netherlands. Fugger can be called a “court bank” with its business model centred on financing

The problem with the role of banks









13

princes and their wars against security (or management concessions) in mines and agriculture. I have chosen the Sevillian banks because they, as a group, suffered the consequences of a warring king in spite of an overwhelming inflow of gold and silver from America brought in by treasure fleets (alas sometimes delayed) to Seville and deposited (on demand) in its banks. I have chosen Barings Bank of London, a merchant bank that did well over the period of the industrial revolution and the “hockey stick” effect that McCloskey (2006) discusses. The failure of Baring came with the new times of IT and de-regulation when it lost control over a “rouge” trader with a talent for hiding trading losses in an “integrated” information system. I have chosen the Royal Bank of Scotland of Edinburgh because it was managed by fear and hubris at the top in times when banks worried about coming “into play”, i.e., becoming a target for takeover bids by predatory capital. I have chosen Kaupthing (and its fellow banks) of Reykjavik because it is such an incredible case. Three large banks going international from a base in a country with no more than 350,000 inhabitants on that beautiful, volcanic, Atlantic island, beyond the Polar Circle. Vikings that ventured to discover America 1,000 years ago!

For each case I will describe the three aspects mentioned: ideas, practices and bank activities, and try to see patterns. The choice of banks that failed may give clues as to what should not have been part of the business model (or indicate that members did not live up to their identity given by the business model), or that the business model was not aligned with the changing circumstances. As the saying goes: one should learn from mistakes! It would be nice if we could learn from the mistakes of others rather than one’s own – and much cheaper!

1:5 Method There is little use for doing original research – digging out data from archives, correspondence and the like – when dealing with a problem like this one. We do not even know if there are clues to find or how they relate to each other. Prospective research is the proper name for this. In such cases it seems a good idea to ride on the back of what others (more competent practitioners of their speciality) have already done. When seeking information about the conduct of management in the Medici bank there is no source equal to de Roover (1963); checking some other books, like Soll (2014), on the topic we see that much of what has been written later builds on this source. For the background in the form of the ideas about society and the role of finance I have relied on Langholm (1979, 1984, 1992, 1998) for early scholasticism, and Grice-Hutchinson (2015) for the School of Salamanca.

14

The problem with the role of banks

Guiding ideas 1250

1650

1950

Deduction from holy text Enlightened Transition

Soul at ransom – the grip of religion

Science & Engineering

Church Fathers

Mercantilism

Scholasticism

2008

Deduction from scientiic texts

Neo-liberalism Scientism Libertarianism

Aristotle Good Banking Medici Fugger

1494

Baring

1650?

1995 Royal Bank of Scotland 2008

Sevilla banks 1553/1576

Icelandic banks

2008

Six failed practices Figure 1.2 The path ahead

For the Fugger bank I have relied on Ehrenberg (1928) and for the ideational background the interest focuses on the Doctors of Salamanca (Grice-Hutchinson 2015), especially since the Fugger house was closely linked to the Habsburgs and their problems in Spain with financing war. The special competence of Fugger to relate credits to mining in different forms suited them well, since the Americas had been discovered, and mining for precious metals (El Dorado!) was on everybody’s mind. Fugger was almost from the beginning a “court bank” and its liaison with Catholic Habsburgs increased the risk of loss in the Thirty Years’ War. The banks of Seville no doubt thought they had arrived in El Dorado without moving anywhere as shiploads of gold and silver arrived to be deposited in their vaults (for now). Still the decline of the Spanish nation seems to have started with these riches, and the banks went bankrupt. What happened? Here I have relied on my friend Salvador Carmona for help with the details of the Sevillian banks and the Spanish court under Habsburg. Salvador Carmona (et al. 2013) also made an interesting study of the problems with reference to the South Sea Company that a Spanish army captain (Salinas) experienced in Buenos Aires in the early 18th century as a consequence of Spain losing another war and having to hand over the monopoly of slave trade on Latin America to that company in 1713. Grice-Hutchinson (2015) is indispensable of course, but Salvador also advised me on selecting a number of Spanish economic historians who have written about this time. After the three banks that existed mostly under the regime of the Catholic Church and scholastic scholarship there is, at least in my account, a transition to

The problem with the role of banks

15

modern times and more State control. This transition included the Enlightenment, mercantilism and the building of a State with administrative capacity for “hierarchical control”. Here I have relied on Schumpeter (1954), Magnusson (1999), and Heckscher (1931). The “problem” of the exceptional economic growth during the 19th century discussed by McCloskey (2006), the “hockey stick effect” I try to cover by an account of the development of a prominent merchant bank, Barings, which is described by Banks (1999). Then came the disastrous collapse of the financial sector in 2008, followed by recession in many countries, and emergency help from international institutions to countries in deep trouble due to sovereign debt. The issues are very complex and entangled but it seems rather clear that there was a strong undercurrent of ideas from neo-liberalism, and especially in the USA, of libertarianism, that provided fertile ground for de-regulation (as a means of competition initially (the Big Bang), but as a religious belief later on). The effect of this (de-regulation) was a completely new terrain for competition in the financial sector with growth by acquisition as a means of protecting oneself from “coming into play” (a), as well as means to grab market shares at the expense of the customer (b). This was incentivized by bonuses on many hands. The 2008 crisis must be considered a stunning collective failure of the actors in the financial sector, and of the theoretical backing for financial technologies from academia. Bernanke said (on 24 September, 2010) “I would argue that the recent financial crisis was more a failure of economic engineering and economic management than of what I have called economic science” (quoted from Mirowski 2013, p. 188). I would respond paraphrasing Aaron Wildavsky’s (1975) statement about PPBS (a world-wide failure of the Planning, Programming, Budget, System for the public sector) that was tested for the public sector in most economically advanced countries in the late 1960s: “We only have one world! The theory of Finance has been tested in it! It did not work!” Is that too harsh a sentence? Perhaps! It remains to be proven. Neo-liberals argue that we are much better off than we were before de-regulation. Piketty (2014) might object. Klamer (2017) may offer alternative views, and Fleurbaey et al. (2018) draw a dark picture, even if there is some hope. It is a matter of how you define “well-off-ness” I guess. Personally, I feel less well-off now than 10 years ago with gang-related shootings coming ever closer to home, fraud on the internet (especially directed toward the elderly), populism, Brexit, and daily postings on Twitter by the great Stable Genius of the West. “But this does not have anything to do with Finance!” people say. Perhaps, but it certainly has to do with my personal welloff-ness. Maybe, I am just getting old, but this is how the idea-context works. I read off the ideational and practical context and form a set of principles on how democracy, governance, competition etc. should work. I believe the many bankers I have interviewed over the years are like me in that way. I have felt a strong affinity with them – most of them are regular, upright people to admire for their diligent work. But they are caught up in a mesh of ideational and practical principles they do not like but have to cope with.

16

The problem with the role of banks

I have chosen to go into some detail on neo-liberalism and libertarianism for idea-background, and Fraser’s account of the history of Royal Bank of Scotland, plus annual reports, the official commission reports, and some articles on the Icelandic banks (Kaupthing, Glitnir and Landsbanki) to get a glimpse of the business models at work in extreme conditions. In the latter case – the Icelandic banks – the interest is so much the greater since it seems like all Scandinavian banks managed to distance themselves from the banks of Iceland in good time before the crash, thus avoiding losing money on them. How come others, not least customers in the UK and Netherlands, did not see what was coming? Aren’t financial markets transparent and well-functioning after so many years of de-regulation?

1:6 Analysis One might wonder how any evidence, one way or the other, can come out of describing banks in their practical and ideational contexts, especially when those descriptions are based on what others have written? To answer that question, I must dwell for a while at epistemology (what counts as knowledge defined as “justified true belief”). There are two ways (of course there are many schools of thought in this area, but I want to use two to achieve contrast) of thinking about how we justify our calling a statement “knowledge”. History (and Popper) tells us that knowledge is not for ever – it is provisional until proven invalid. Much of what was knowledge when I started out as a student many years ago is now dismissed as obsolete or “folk lore”. Things change particularly fast in social sciences, and today. Therefore, we should be aware of what we count as knowledge and on what basis. It certainly cannot be subject to vote or decided by committee (or journal editors). One way is to use logic to deduce premises for a statement’s truth, step by step until you arrive at a basic statement that is obviously true – no further proof is required. Call this foundationalism. In many economic theories, such basic truths have initially been put there by assumptions. Another way is to rely on coherence so that a set of statements are found to support each other to such an extent that we may harbour a justified belief that any of the statements is true by virtue of mutual support. Call this Coherentism. Social constructivism, which appears quite frequently in social sciences, may be expected to use that kind of approach to justified beliefs. The problem here, obviously, is to decide when any link in such mutually supporting statements has been undermined by counter arguments to the extent that the belief is no longer justified. The solution is to present your argument and listen to critique in scholarly dialogue. In “Coherentism” the form of the evidence will tend toward narratives, while “Foundationalism” will strive toward measures in accordance with proper procedure. With Coherentism one may benefit from using historical accounts of events and processes, but always, of course, be alert to emerging counter evidence. In proper historical research, one is taught to be critical of

The problem with the role of banks Foundationalism

17

Coherentism

G (is true) Supports Logic E

F

A

B

Supports

Supports

Logic D A

B

C

Supports

C

D (obviously true)

Figure 1.3 Foundationalism and Coherentism as formulations of justified beliefs

the sources one uses as evidence. Using accounts given by respected historians that have been subject to critical examination by fellow historians might generate a false sense of correctness. Any historical account will typically use a number of other accounts as evidence or counterarguments. Not having done the basic work of scrutinizing the evidence oneself means that one has a rather weak basis for choosing between competing accounts. The reader should be aware of the dangers, just like the use of Likert scales to achieve measures for calculation should be viewed with suspicion. One example of justified belief (suspending the “true” for the moment) is when religion is used as an authoritative source for regulating proper conduct. This was part of the dominating context in medieval banking. Another is when libertarianism – the assumption that the State is corrupt because of the immoral influence of “special interests” (like unions) and therefore must be reduced to a minimum – is used to justify de-regulation. Market will take care of all problems; the winners will be the good guys, and the losers will be the bad. What we need is a constitution that protects the minority (the good guys) from abuse by the majority (like unfair taxes) libertarians say. Well, we usually do not mean that either of these “religions” are justified by logic or scientific measurement! We have to scrutinize the rhetoric they use for justification. Rhetoric often appeals to emotion rather than logic, and is powerful enough to be used to create majorities from diverse groups using Big Data and profiling. In the old days the rhetoric had to do with how we could secure a safe path in afterlife. Logic as well as rhetoric will have different persuasive power in different contexts. That will have an effect on how banks go about their business to preserve their “good name”.

Notes 1 The book was published after his death, carefully edited by his daughter Elizabeth Boody Schumpeter. 2 Kaminsky & Reinhart (1999) show that, after 1970, financial crises can be linked to financial liberalization in 18 out of 26 investigated crises.

18

The problem with the role of banks

References Ahir, Hites & Preakash Loungani (2014) There Will be Growth in the Spring: How Well do Economists Predict Turning Points? VOX CEPR Policy Portal Akerlof, George A. & Robert J. Shiller (2015) Phishing for Phools. The Economics of Manipulation and Deception. Princeton: Princeton University Press Banks, Eric (1999) The Rise and Fall of the Merchant Bank: The Evolution of the Global Investment Bank. London: Kogan Page Black, Fischer & Myron Scholes (1973) The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3): 637–654 Boltanski, Luc (2009) On Critique – A Sociology of Emancipation. Cambridge: Polity Press, 2011 Boltanski, Luc & Laurent Thévenot (2011) On Justification – Economics of Worth. Princeton: Princeton University Press Carmona, Salvador, Rafael Donoso & Stephen P. Walker (2010) Accounting and International Relations: Britain, Spain and the Asiento Treaty. Accounting, Organizations and Society, 35: 252–273 Carmona, Salvador, Rafael Donoso & Philip M.J. Reckers (2013) Timing in Accountability and Trust Relationships. Journal of Business Ethics, 112(3): 481–495 Cooren, Francois (2010) Action and Agency in Dialogue. Amsterdam: John Benjamins Ehrenberg, Richard (1928) Capital & Finance in the Age of the Renaissance: A Study of the Fuggers and Their Connections. London: Jonathan Cape Fleurbaey, Marc, Oliver Bouin, Marie-Laure Salle-Djelic, Ravi Kanbur, Helga Nowotny & Elisa Reis (2018) A Manifesto for Social Progress – Ideas for a Better Society. Cambridge: Cambridge University Press Friedman, Milton (1982) Capitalism and Freedom. Chicago: Chicago University Press; original 1962 Grice-Hutchinson, Marjorie (2015) Early Economic Thought in Spain 1177–1740. Indianapolis: Liberty Fund Heckscher, Eli F. (1931/1935) Merkantilismen: ett led i den ekonomiska politikens historia. Stockholm: Norstedts. (Two volumes – English Version “Mercantilism” trans. by Mendel Shapiro. London: Macmillan) Hobbes, Thomas (1651) Leviathan or The Matter, Forme and Power of a Common Wealth Ecclesiasticall and Civil. London: Crook Kaminsky, Graciela L. & Reinhart, Carmen (1999) The Twin Crises: The Causes of Banking and Balance-of-Payment Problems. American Economic Review, 89(3): 473–500 Kindleberger, Charles P. (1989) Manias, Panics and Crashes – A History of Financial Crises. New York: Basic Books Klamer, Arjo (2017) Doing the Right Thing – A Value Based Economy. London: Ubiquity Press Korsgaard, Christine (1996) The Sources of Normativity. Cambridge: Cambridge University Press Lanchester, John (2008) Cityphobia. London Review of Books, 30(20–23): 3–5 Langholm, Odd (1979) Price and Value in the Aristotelian Tradition – A Study in Scholastic Sources. Oxford: Oxford University Press Langholm, Odd (1984) The Aristotelian Analysis of Usury. Oslo: Universitetsforlaget Langholm, Odd (1992) Economics in the Medieval Schools – Wealth, Exchange, Value, Money and Usury According to the Paris Theological Tradition. Leiden: Brill

The problem with the role of banks

19

Langholm, Odd (1998) The Legacy of Scholasticism in Economic Thought – Antecedents of Choice and Power. Cambridge: Cambridge University Press MacKenzie, Donald A. (2006) An Engine, not a Camera: How Financial Models Shape Markets. Cambridge, MA: MIT Press MacKenzie, Donald A. (2018) How to Solve the Puzzle. London Review of Books, 40(7): 11–12 Mackenzie, Donald A. & Taylor Spears (2014) The Formula That Killed Wall Street: The Gaussian Copula and Modelling Practices in Investment Banking. Social Studies of Science, 44: 393–417 Magnusson, Lars (1999) Merkantilismen – Ett ekonomiskt tänkande formuleras. (English: Mercatilism – Economic Thinking is Formulated) Stockholm: SNS McCloskey, Deirdre N. (2006) Bourgeois Virtues: Ethics for an Age of Commerce. Chicago: Chicago University Press McCloskey, Deirdre N. (2010) Bourgeois Dignity: Why Economics Can’t Explain the Modern World. Chicago: University of Chicago Press McCloskey, Deidre N. (2016) Bourgeois Equality: How Ideas, not Capital or Institutions Enriched the World. Chicago: Chicago University Press Meek, Ronald (1957) Is Economics Biased? A Heretical View of a Leading Thesis in Schumpeter’s History. Scottish Journal of Political Economy: 1–17 Merton, Robert K. (1968) Social Theory and Social Structure, New York: Free Press (orig. 1949) Mirowski, Philip (2013) Never let a Serious Crisis go to Waste – How Neoliberalism Survived the Financial Crisis. London: Verso Otteson, James R. (2002) Adam Smith’s Marketplace of Life. Cambridge: Cambridge University Press Piketty, Thomas (2014) Capital in the Twenty-First Century. Cambridge, MA: Harvard University Press Reinhart, Carmen M. & Kenneth S. Rogoff (2009) This Time is Different – Eight Centuries of Financial Folly. Princeton: Princeton University Press Roover, Raymond de (1963) The Rise and Decline of the Medici Bank. Cambridge, MA: Harvard University Press Schumpeter, Joseph (1954) The History of Economic Analysis. London: Allen & Unwin Smith, Adam (1759) The Theory of Moral Sentiments. Edinburgh: Millar Smith, Adam (1776) An Inquiry into the Nature and Causes of the Wealth of Nations. London: Strahan & Cadell Soll, Jacob (2014) The Reckoning: Financial Accountability and the Rise and Fall of Nations. New York, NY: Basic Books Streeck, Wolfgang & Philip C. Schmitter (eds) (1985) Private Interest Government: Beyond Market and State. Beverly Hills: Sage Swedberg, Richard (1991) Schumpeter – A Biography. Princeton: Princeton University Press Viner, Jacob (1954) Schumpeter’s History of Economic Analysis: A Review Article. American Economic Review, 44: 894–910 Wildavsky, Aaron B. (1975) Budgeting: A Comparative Theory of Budgetary Processes. Boston: Little Brown Wittgenstein, Ludwig (1953) Philosophical Investigations. London: Macmillan

2

Community as centre of authority Banks are squeezed between the necessities of business, power politics, and the afterlife

In this Chapter 2 I try to show how difficult it is to live up to your identity (Korsgaard 1996), when you are torn between your role as a true Christian, a true servant of the prince, and your duties as leader of the family business. We will see how the condemnation of usury in the holy texts was circumvented by emerging practices, which initiated response from wise men re-interpreting the holy texts. But primarily we will see how princes, most of the time at war (on credit) resorted to ever harsher methods to collect the necessary funds. This, in turn required a supporting staff of public officials to manage the ever-increasing problems with “sovereign debt”. Banks that did not keep out of these “power fields” would perish – sooner or later.

2:1 Religion It seems like the early Christians saw a distinct link between money/wealth and the afterlife (Brown 2015). First there was the dominant idea that martyrs will come instantly into the presence of God. Death and afterlife for the ordinary Christians was of little concern in the 250s AD – and there was not very many of them (Cyprian, the bishop of Carthage, a small congregation, wrote early texts at about 250). Tertullian wrote even earlier that after death the souls of the dead live in limbo in wait for Resurrection and the Last Judgement. This view of souls in waiting soon lost currency in Western Christianity. Now the words of Jesus to the Rich Young Man “If you would be perfect, go, sell what you possess and give to the poor, and you will have treasure in heaven” came into focus. But that big, heroic gesture was not always required, small gifts, alms, would do. The hope was that the Creator would reward mercy with mercy. The living can prepare the way to Heaven by alms. By intercessory prayer the living could also smooth the way for their dead loved ones. Almsgiving became a standard part of funerals. Furthermore, as the catacombs of San Sebastian (south of Rome) show, there were facilities close by the tombs for having a meal – refrigerium – with the dead. From the third century Christianity gained in importance with the conversion of Emperor Constantine (in 312). This meant that, with him, there were rich Christians in the community and the poor came still more in focus (while

Community as centre of authority

21

STATE “Hierarchical Control”

“Theory/Debate” / Principles

“Theory/Debate”

Practices Principles

MARKET “Dispersed competition”

COMMUNITY “Spontaneous Solidarity”

Figure 2.1 Community as a centre of authority

the martyrdom was more or less forgotten as a portal to heaven). With this there was also a sense of difference between souls. Some were on a fast track to Heaven. St Augustine (422) introduced doubt again in Enchiridon, written like a handbook for Christian laymen. When faced with the questions about to which extent different rituals “worked” his answer was “God only knows”, but in trying to sort things out he would distinguish between the valde boni (altogether good), who could be assumed to reach heaven with no difficulty, and the valde mali (altogether bad), who were destined for hell. This left the middle group (non valdes), which St Augustine said could be helped by prayers and offerings provided that they had qualified by living a reasonably good life. Now the church was taking a dominant role in Roman society, a church of non valdes. This middle group needed guidance and articulation of the specific rules that apply if you want to save your soul. Divine Law and Natural Law supported each other over the centuries and took on a new significance as the new universities, springing out of the monasteries, which in turn was the result of Charlemagne’s edict in 787 (usually called the Charter of Modern Thought) initiating educational reform to be carried out via these monasteries. The universities, Paris, Oxford etc., many organized by monasteries, were dominated by their theological faculties where the meaning of Divine Law as applied to current contexts was explicated. In time, Aristotelian ethics was used to support recommendations. Still the Church was

22

Community as centre of authority

in control and its rulings constituted the regulation of conduct that all must observe, like avoiding usury. The parish priest was at hand to advise. The resistance to the Catholic Church (and its allied princes) as the sole authority in regulation came to be challenged in the 16th century by Protestants. This was met by the Catholic counter-reformation (with Jesuits as the vanguard) and climaxed in the devastating Thirty Years’ War. At the end of the war, around 1650, Europe looked different. The State had emerged, built by professional bureaucrats led by competent administrators like Johan de Witt of Holland, Jean-Baptiste Colbert of France, and Robert Walpole of Britain, and financed by taxes, tariffs, and money market loans. Empires were built, East India companies formed, and debates on the flow of money in and out of nations (mercantilism) created opportunities for the bourgeoisie to prosper (McCloskey 2010). Science was in focus and rationalism, deductive reasoning based on observational facts, carried us into modernism, which stimulated thoughts about large scale investment in production capacities to refine the raw material arriving from overseas. Banking assumed a new role (and moved to London), gradually losing the direct contact with the material goods of trade and manufacturing. The liberal economy was carried by a set of ideas with the investing individual at the centre. Liberalism, stumbled, challenged as it was by socialism (and war). Building a new, German, Austria after the First World War required struggle against socialism, and articulation, in Vienna, of what a modern liberal marketbased nation should look like. Having failed, in the sense that dictatorial leaders plunged the world into another war, the need to articulate and further the market-based economy was felt even stronger by a group of economists and concerned businessmen who formed the Mont Pelerin Society in 1947 to provide an ideological platform, where economists like Hayek, Friedman, and, later, Buchanan found an engaged audience for Austrian micro-economics, neo-liberalism and libertarianism (to be discussed later). A new religion would take its grip on our minds – the market.

2:2 Finance In the old communal life where families lived close together in villages for mutual support the decent thing was to lend whatever you could muster to help a neighbour in need over a limited period. The next time it would be the other way around. To charge interest from somebody in need was not the thing to do. With trade the profit motive is evoked as the merchant seeks to exploit geographical differences in price (arbitrage – buy cheap where there is plenty and sell dear where there is scarcity). What constitutes a fair price came to be a topic of discussion, as was usury (Langholm 1979). At the centre of the argument, since Aristotle – his Nicomachian Ethics, had been re-introduced in Europe around 1250 – was free will. A contract was valid if and only if, it had been entered by two competent parties of free will. Interference with free will could come from three sources: Threat (fear), Ignorance, and Need (Langholm

Community as centre of authority

23

1984). The Christian scholars in Europe that articulated the principles that a good Christian has to live by, focused on the validity of contracts between individuals. There was no conception among early (Paris) scholasticism of a market beside the ancient Greek tradition of free contracting, and that a thing is worth what it can be sold for. The analysis of individual cases hinged upon whether the free will of any of the parties had been interfered with. Fractional banking (lending out other peoples’ money while holding less than 100% of deposits in reserve), and the role of the money supply (and secondary markets?) came into view later, as the second era of scholasticism in the 16th century, centred in Salamanca, commented on the troubles of the banks of Seville and their bankruptcies. With that, mercantilism was in the making, and the Doctors of Salamanca had provided the groundwork by trying to figure out what had gone wrong with declining Spain in spite of the fact that silver and gold was flowing in from the Americas.

2:3 Divine Law and usury Marjorie Grice-Hutchinson (2015) provides insights into how the Abrahamic religions (Judaism, Christianity, Islam) view usury. In all cases we have sacred texts and interpretations by recognized authorities to build on. There were, of course, practices in financing transactions that aimed to circumvent the very strict rejection of usury in all three religions. In response to such trickery, revision of earlier comments by the wise men was required, in order to deal with the new phenomena. The Hebrew texts were the oldest and much of their pronouncements were repeated in the later ones, especially in learned comments. This was because practices travelled with trade. In general, the rejection of usury among people of the same faith was complemented by a greater permissiveness when dealing with infidels. Islam, being the youngest of the three, had the strictest rejection of usury practices, with the consequence that, over time, the regulation of financial practices became increasingly difficult as the inventiveness of money-changers and merchants increased. 2:3:1 Jewish texts Grice-Hutchinson (2015) lists the passages of Jewish texts (the Bible and the Talmud – the latter made up of the commentaries Mishna and Gemara – a compilation that was completed about the year 500 – that deal with usury. She notes that some principles are designed to protect the poor, but usury between Israelis is also prohibited altogether. It was the rabbis that had to interpret the texts for application. The Talmud contains instructions to this end often by examples. One can, for example, interpret the Mishna as permitting trading in futures (while lending against interest was strictly forbidden). Merchants came to use “double contracts” (mohatra or barata contract – a deal is divided up

24

Community as centre of authority

into two transactions, each with a separate contract – I lend you money and you, in return buy some goods from me and sell them back immediately at a lower price) to avoid being accused of usury. Several other evasionary devices are mentioned in Talmud. An interesting one is the rejection of one Israeli accepting from another an “iron flock” (meaning that the investor assumes all the risk and the lender none). Talmud in general resisted the transfer of money by way of financial instruments – the practice was to transfer money in sealed purses with the quality of the metal and weight noted on the outside. Jews living in diaspora and meeting other cultures and customs faced problems of interpretation of how the texts should be applied in specific contexts. This gave rise to a flow of questions to centres of learning, first in the east, in Mesopotamia (Sura and Pimbedith), and later in North Africa and Spain (Cordoba, Toledo, and Lucena). This was a very slow method of getting a “responsa” to moral problems that faced the local merchant about to enter a deal. In time local collections of “response” emerged, with the learned centres as “back offices”. By and large, the impression is that texts on proper conduct in Judaism developed over the Medieval times as case by case responses to questions posed to rabbis and transmitted to the centres of learning. One exception may be Maimonides, a scholar from Cordoba, who after fleeing persecution in Spain came to live in Egypt, where he wrote his Code based on a large number of sources. This text was granted great authority, dealing as it did with a large number of problematic practices involving usury and quasi-usury. Grice-Hutchinson (2015, p. 15) finishes her account for Jewish Law with the words: Altogether, with such an array of evasionary devices to choose from, it is unlikely that any Jew who was seeking a profitable investment would be unduly troubled by the fact that usury (between Israelis at least) was in principle forbidden by the law of his people. 2:3:2 Usury in Islam Islam is the younger religion of the three Abrahamite ones. When the Quran was written the Jewish scholastics and practices were already in a period of adaptation to current practices and compromise. Mohammed was shocked by the “backsliding” of the three Jewish tribes of Medina. So, he saw to it that the Quran prohibits the taking of usury in harsh words, and it is important to uphold the condemnation of riba (usury) as well as gambling (maisir). Riba in Islamic law is an excess according to a legal standard measurement (of capacity, not length) or weight, in one of two counter-values opposed to each other in a contract of exchange, in which such excess is stipulated

Community as centre of authority

25

as an obligation falling on one of the parties, without any compensatory advantage being received by that party. (Grice-Hutchinson 2015, p. 17) Also, it is stipulated that the two articles must be exchanged simultaneously (if one party is stipulated to pay later it is usurious). Gambling prohibition includes the clause that contracts must be stated clearly (no unspecified quantity allowed). Money-changing was strictly regulated (gold for gold, hand-to-hand, of equal weight). Transfer of money via the financial instrument called suftaja was, therefore, suspicious because of the stipulation “hand-to-hand”. Just as in the Jewish tradition there was a large number of practical devises to avoid accusations of riba. The hiyal, a body of well recognized legal fictions (e.g., the double contract of sale, in Arabic, mukhatara), was used. A good hiyal lawyer could reconcile commercial practices with the rulings of the Islamic judge. Muslims were instructed to take a contract of a loan to the notary to register the terms, particularly the date of payment. Written documents formed an essential part of the hiyal. Jurisprudence was a favourite profession in Muslim Spain since it opened career opportunities in the State (Grice-Hutchinson 2015, p. 19). There were many writers on Islamic Law; Ibn Asim (1359–1426), for example, was the chief kadi (judge) of Granada. He devotes a large number of chapters to commercial issues in his treatise Tuhfa. He, in general, leaves the parties to contract freely, but is strict about usury: “To lend is legal; it is an act commonly practiced in all things except women. A loan must not produce a profit.” (Grice-Hutchinson 2015, p. 20). One may doubt whether he was successful on this account in his practice as judge. 2:3:3 Christian rules on usury Grice-Hutchinson (2015, pp. 20ff.) points out that the situation concerning Christian doctrine on usury is somewhat more complex since the sacred text (New Testament) gives only one pronouncement on usury (Luke VI:35): “But love ye your enemies, and do good, and lend, hoping for nothing again.” Therefore, we need to rely, besides tradition, on canon law as pronounced by the Church as well as Civil law often influenced by Aristotelian ethics. The account given below also makes use of the work by Langholm (1979, 1984, 1992, 1998). Early commentators pointed out that the Old Testament and Mosaic Law prohibited usury between “brothers”. They extended the area of application to Christians (those participating in the same Logos). But these early commentators were moralists. The legal aspects of usury were first treated in Corpus Juris Civilis compiled at the initiative of Justinian in 528 AD. Two types of loans were identified, those involving fungibles (goods that can be counted, measured and weighed), a mutuum for which interest up to 12.5% per year could be charged (then it

26

Community as centre of authority

would be called a foenus), and commodutum (the same goods must be returned, like a house or a horse). The risk of damage to the goods was carried by the lender. If “interest” were charged then it became rent or a hire. The regulation of usury was oriented toward a maximum limit. The Western church had to deal with commercial practices adopted from the trade with the Levant. Grice-Hutchinson (2015, p. 25) gives a telling example of the difficulties in a quote from the Decretales (1254): when merchants buy pepper, cinnamon or other merchandise which at the time of the contract are worth not more than five libras, and promise in a public instrument to pay the vendor six libras at the end of a stated term. While this contract is not exactly usurious the vendor is nevertheless blameworthy. These complex issues (the prosperity of a city hinged on trade) together with the increased persecution of the Jews from the time of the Crusades, and the push-back of Muslim power in Spain mobilized the Church to become stricter on usury. After the compilation of regulations (in 1139–1141) by Gratian came the Decretales (in many versions), which added papal canons and decretals to the earlier compilation. One such papal canon prescribes that when land or other property is held in pledge (church institutions usually invested their surplus this way), and the lender enjoys the fruits of the property over the time of the loan, these fruits must be considered when the loan is settled. Another practice regulated in the Decretals is sea-loans (a practice that goes back to Antiquity) where the lender advances money on a ship or cargo with the understanding that the loan is to be paid back with a premium if the voyage is successful, but the loan will not have to be repaid if the cargo is lost. This, obviously, is an early form of insurance. Such a practice was now deemed usurious if the premium was justified by the lender assuming the risk. These stricter rules can be seen as part of the reconquering of Spain and the efforts to drive out Jewish and Muslim customs. The energy to take these steps seems to have come from the newly established religious orders, the Friars and the Dominicans (Munro 2001, p. 5). The Pope, Gregory IX, backed this up with the Decretales (of 1234), which confirmed an earlier decree and listed harsh punishments for usurers. An important component in this new regulatory fervour was the re-discovery of Aristotle’s Nicomachean Ethics (349 BC) that inspired the scholastics (see below). The campaign went as far as threatening, in a decree of the Council of Vienne (1311), with excommunication for all magistrates, consuls and similar officials who set up statutes that permit usury, or “knowingly” decide that usury may be paid. At this time Dante published his Divine Comedy, where usurers are placed in the last class of sinners that are punished in the burning sands at the lower depths of the Seventh Circle of Hell. Even if enforcement mostly included excommunication by the Church for open and flagrant usury, hidden usury was still a mortal sin with the ultimate punishment of eternal damnation. Therefore, the

Community as centre of authority

27

regulatory force of the prohibition of usury by the church was its “hold on men’s soul and that no evasion was possible” (Munro 2001, p. 15). The scholastics argued the case eloquently (Langholm 1984) with focus on the following. 1 2 3 4

The usurer sells time (time belongs to God). The ownership of the money passes to the borrower and any gain from the loan thus belongs to him (taking usury is robbery). Money is consumed in use and therefore has no value separate from its use. Money is sterile, i.e., it is a fungible, and therefore has no value beyond its substance.

We tend to dismiss such claims as built on superstition – we know much better now, and with certainty about individuals’ utility, markets’ equilibria, and demand curves with price elasticities. Every businessperson knows this! However, the arguments presented then were crafted in that particular context, and, after ca. 1250, there was a new kind of energy in the scholastic debate since Aristotle’s Nichomachean Ethics (350 BC) had been reintroduced to the West. Langholm (1984) presents and interprets in a new way, the standpoint of scholastics on usury with a concluding explanation of why the modernist economists have misunderstood and misrepresented it. Why is that interesting? Because it has a bearing on how the problem of usury was solved then and now. Langholm’s argument is as follows. Böhm-Bawerk (1890) in his great work on interest theory, more than a hundred years ago, formulated three assumptions that have since been the basis for two lines of development of interest theory. One such line, which has usually been associated with Irving Fisher, but was initiated by Jevons, may be called the psychological line. It assumes that people prefer money now rather than in the future just because the pleasures of enjoying it are more proximate now. It was especially pointed out that some thoughtless, often poor, people, have this propensity. The other line, initiated by Carl Menger, and developed by economists like Knut Wiksell, Schumpeter and Hayek, is based in theories of economic growth that provides “investment opportunities”, and, therefore, interest is an opportunity cost. Langholm starts by referring to Schumpeter (1954), who noted, without further development of the characteristics of the stationary economy, that in such an economy with its circular flow, or in a market in equilibrium, it is, by definition, impossible to find profitable investment. Risk was not a central concern to scholastics since they focus on contract between equals (who always pay). One should also consider the context, which included little of credit institutions (with Bills of Exchange between merchant houses as an occasional exception). Lending money, then, was a matter between individuals with the

28

Community as centre of authority

lender, who has money, in a monopolist position vis-à-vis the borrower. There are no investment opportunities in this discourse. Neither will one find any scholastic who does not accept the principle that a thing is worth what it can be sold for (“in the absence of ignorance, fraud and duress”). The problem is how to establish par (what is a fair price) when either party is not satisfied or when any of the mentioned manipulations/deceptions is present. The scholastics accepted trade as a good thing. The person with a surplus of potatoes gets it reduced by exchange with the baker and at the same time eliminates his deficit of bread. Both are better off. Money was invented to make trade easier. Money was seen as coin with a value stamped on it. It was a sterile instrument whereby the value of potatoes and bread could be compared. In the “absence of fraud and ignorance, and deducting for legitimate extrinsic titles, a positive rate of interest on a money loan must always, because of the sterility of money, be the result of undue pressure on the borrower” (Langholm 1984, p. 144). This kind of exploitation of the needs of the borrower is equal to robbery. Langholm discusses further details on the status of the transaction when the borrower consents to paying usury. One might use Aristotle’s own famous example – about the captain who throws cargo over board in a storm to save the ship – as an argument for paying interest, since that was an example of free will even if it was “mixed will”. But No! The borrower paying interest out of free will cannot excuse usury because he is forced by his need for ready money (not by Nature as in the case of the captain saving his ship)! How can this kind of reasoning be understood? Langholm starts, with the nature of an equitable contract. Referring to Aristotle’s Ethics, Book V, he points out that the discussion there is about justice (what are the principles of equivalence in exchange?). This is where scholastics found inspiration in the determination of the “just price”. There are various ways of setting prices. Sometimes the Sovereign may determine the price, iudicatum, (e.g., to limit the damaging effects of scarcity), sometimes the parties agree among themselves, pactum, and sometimes the terms of contract are determined to comply with parity or equivalence in a strict sense, contrapactum. In cases of disagreement between the parties, some rules of thumb had to be present for judging whether a price was fair or not, and also whether a contract was valid. Such judgements could have two purposes: (1) to arrive at correctives to the proposed price or (2) to check whether the actual terms of the contract indicate that free bargaining had been operative. (It should be noted that Thomas Hobbes ridiculed this idea of equality and claimed that justice is a technical term referring, not to the terms of the contract, but to the performance of covenant.) Now, with free bargaining, a thing is worth what it can be sold for, provided that the buyer knows what he buys. Consent (the borrower paying interest voluntarily) presupposes understanding of the terms of the contract. Given such understanding we arrive at the border case of conditional consent, which, again, is illustrated by Aristotle

Community as centre of authority

29

by the captain’s decision to toss cargo overboard to save the ship in a storm. The captain was subject to compulsion from an impersonal force (the storm) but can be said to have made the decision to toss the cargo voluntarily. When it comes to coercion (duress caused by a human agent), the issues are more difficult to resolve because of the scholastic focus on justice between individuals (not collectives). But there is the same double face of the situation, since the need of the borrower stems from intended use of the money. The borrower consents to pay usury willingly in order to be able to use the money, even if he would prefer to have it for free. Now Langholm reminds us that if you accept the principle that a thing is worth what it can be sold for there is no basis for deciding between disagreeing parties (we need some objective value for that). This is where the cost basis for determining a just price comes in. There were two schools among later economists as well as among scholastics, cost or market. But in a stationary economy there is every reason to believe that the two will come together. Furthermore, the tendency among modern debaters to look upon one party’s profit as the other party’s loss is mistaken. Both parties benefit from the exchange! (no zero-sum game!). The utility of the borrower should not matter (corn for the starving child vs truffle for the bishop’s table). In time, the scholastics came to focus on necessities (and leave the price of luxuries free). Still there was an opening for the lender to use the “cost” argument for charging legitimate interest, either because abstaining from the sum of money would cause him “emergent” loss (damnum emergens) and/or foregone “cessant” gain (damnum cessans). Langholm claims to have shown that “cost” and “market” are really two sides of the same doctrine in a stationary economy. He suggests that we should refer to the analogy of the “just price” (as far as it goes) in order to understand the Aristotelian discussion of usury. Next Langholm turns to the teleology (purpose) of money. Long before the scholastics had access to Aristotle (about 1250) the idea that usury was wrong because “it forces a fruit from sterile money” had travelled from the east via the writings of Church Fathers. The basic attitude of the scholastics vis-à-vis the purpose of money was that it was invented to make trade easier: “usury (obolostatica) is most reasonably hated, because its gain comes from money itself and not from that for the sake of which money was invented” (Moerbeke’s translation (to Latin) of Aristotle’s Politics). The key word here – “obolostatica” – literally means “weighing of coins” and therefore Aristotle might have meant “debasement of currency”. Thomas Aquinas defines usury as a form of wealthgetting which makes money breed money, but such breeding is against nature! Here Langholm stresses that the most important aspect, when it comes to grasping the Aristotelian theory of usury, is to understand that the theory is based on a conception of money as coin. It is not so much that money cannot breed as the opinion that usury is an unnatural use of money. The idea of what is the “natural” use of money stems, according to Langholm, from an anonymous comment (6th century?) to the scene in the Bible (Matthew) where Christ throws the merchants out of the temple:

30

Community as centre of authority More cursed than all merchants is the usurer, for he sells a thing not bought, as do the merchants, but given by God, and afterwards takes back his good, removing that of another with his own; a merchant, however, does not take back a good once sold.

The point here is that the ownership of the money lent is transferred to the borrower, and whatever he uses it for cannot be taken back by the lender. How is it then – was the counterargument – that a house or a horse can be lent against a fee stemming from the benefits of use by the borrower? Ah, but in these cases the ownership does not pass to the borrower. But since the value of the things mentioned deteriorates with use, which money does not, the doctrine, in time, had to be limited to fungibles – things that could be returned in kind, of the same quality (like corn, wine, coin). Langholm points out that risk was never an argument for charging interest in scholasticism. Focus was on the concrete coin form of money (not on the abstract purchasing power idea). Thomas Aquinas settled the matter “All other things have some utility from themselves, money, however, has not, but is the measure of the utility of other things. Therefore, usury amounts to “diversifying the measure” (money should be paid back in exactly what you borrowed). This is the mutuum idea of contract. To include a “use value”, which is entirely fictitious, means “diversifying the measure”. Charging interest, on top of the return of the money borrowed, means selling two things; the substance of the money and the use of the money. Thomas Aquina’s idea here is that the concrete money borrowed is supposed to be consumed immediately, e.g., to buy food. Money does not deteriorate in use, like a horse, it is consumed, completely gone! This argument, that money is consumed, is another way of claiming that it is sterile. Money does not bear fruit! But it does! – later authors claimed. Human industry begets money and makes it bear fruit! True that the borrower reaps some benefit from his use of the borrowed money (if he is an artisan or a merchant), was the answer, but this benefit is due to his industry, not to the sterile money, and cannot be the basis for claiming interest payment on the loan. It was here that the attack on the Aristotelian conception on money came. Francis Hutcheson, Adam Smith’s teacher in economics, argued that “labour employed in managing money in trade, or manufacture, will make it as fruitful as anything” (1755). But it was the “heretic” Franciscan monk Antonino of Florence who first refuted the sterility of money doctrine. Sombart, Weber and Schumpeter comment on this feat, and Benjamin Franklin uses it in his letter “Advice to a Young Tradesman” (the sterility of money was refuted with reference to the “industry” of people). St Bernardino of Siena, one of Langholm’s most quoted sources, is often referred to concerning usury, especially his “De temporis venditione” (sermon 34) dealing with problems of just equivalence in contracts involving a time element. Early scholastics had claimed that the usurer was selling time “a thing not bought but given by God”, which was a sin since time is given to all. The objections came in terms of depletion or growth of value over time. For goods

Community as centre of authority

31

that, with the passage of time, increase in value it is permissible to charge a higher price without this being called usury. Some argued that the injunction against selling time applies only to time in an abstract metaphysical sense, not to duration related to things. However, the Franciscan monk Peter Olivi argued that since the time remaining of the stipulated loan period is time properly belonging to the borrower (for him to exercise his industry), he is free to bargain with the lender about a reduction in the sum to be repaid before maturity. St Bernardino accepted this argument. Noonan (1957), who paid much attention to Bernardino, labels this the worst “blunder in the whole tradition of usury”: Langholm looks at different sources and finds that the anticipating debtor selling back his own time appears quite often in the scholastic literature. What the authors on usury stress is rather that no one should be allowed to make a profit just because time passes. But a merchant may legitimately store goods expecting the price to go up as scarcity sets in? True, but in the case of money, even if the purchasing power falls as the price of the goods goes up, it will, compared to itself, always be worth the amount stamped on the coin. A natural thing (like corn) may increase in value but pushing the value of artificial things above the artifice it embodies, is usury. Langholm returns to Aristotle’s Metaphysics, concerning measurement – an object is measured by the smallest unit of its kind. Even if some kind of measure is required, there is no ground for going beyond first principles in a mutuum. When money is exchanged for money, corn for corn, or wine for wine each thing provides its own measure. In sum, there are three arguments here against paying usury for a loan:   

an object would be valued above its nature or artifice (1) a fruitless object is made profitable (2) with two things of the same value, one is made to increase with the other (3).

This latter argument relates to efforts to separate the value of substance of money from the value of use of the money. But such separation cannot be done since the very purpose of money is to be used in trade – use becomes part of the definition of money. Scholastic authors “clung” to this triple argument for centuries. But then this foreshortening of the time perspective came under attack as psychology came in sight. People prefer money today before money later. Now we are back at Böhm-Bawerk (1890), who identified three necessary assumptions for interest to exist. (1) In a growing economy, there will be more goods available in the future. (2) People tend to underestimate their needs in the future. (3) Entrepreneurs want to start their production process now rather than delay and start later. This third assumption indicated that the capitalistic production process has a time extension. Böhm-Bawerk discusses the money payments over its (production’s) duration. In passing he provides a critique of Marx. (No! Entrepreneurs do not exploit the workers! On the contrary, they

32

Community as centre of authority

pay wages before the work they contributed has resulted in income!) This provided the basis for the dominating branch of interest theory, which looks upon interest as a parameter within economic growth. Langholm’s closing arguments for properly understanding the scholastic position (emergent and shifting as it was) are based in an understanding that scholastics must have held, namely that the economy is not growing. Schumpeter (1954) claimed that in such an economy there is a zero interest. Then there is every reason to look upon trade as contracting between equal parties, and, consequently, to determine what is required for a contract to be valid and a price just. If the two parties agree on the terms, so much the better, but what if either party complains – on what grounds can the proposed agreement be corrected or invalidated? If you, in a stationary economy with no interest rate, find a contract requiring the borrower to pay interest, then the borrower must have been subject to undue coercion. His need was exploited by the lender. The contract is invalid. But, over time, commentators on civil law argued for several exceptions from the general ban on usury; one was the right to impose a penalty payment when repayment of a loan was late, another was the right to compensation for any loss or damage that the lender may have incurred after the loan was granted, e.g., from not having the money available in an emergency. A third exception was foregone potential gain that could have been derived from alternative forms of investment (the alternative cost concept). Religious law commentators like Thomas Aquinas did not accept this latter claim, but there were other practices that tended to undermine the ban on usury: among them, rentes and Bills of Exchange. In sum, we can see that the approach of all Abrahamic religions to the regulation of trade and usury is by reference to sacred texts, and by pronouncements of learned men (rabbis, imams, priests, scholars) on how to apply the sacred texts to specific cases. This was especially important since trade, not least in Spain, involved cultures confronting other cultures, as the peninsula was gradually reconquered from the Muslims. Dealing with such mixed cultures generated a large number of questions to be answered by the academies that grew under the protective umbrella of religion. Some of these centres developed into the first universities, the faculties of which largely consisted of monks in the newly established orders (later also Jesuits). This was the basis for scholasticism – learned men explicating Divine Law. The distinctive features of this social philosophy, when it comes to understanding the premises for banking, was that there was not yet any conception of a “market” (trade was a matter of individual contracts), and, as a consequence, there was little concern for “market price” (seen as a “common estimate”).

2:4 Evolving practices – tricks of the trade To interpret Divine Law as it applied to a variety of circumstances was not an easy task. We have already mentioned several practices that challenged the

Community as centre of authority

33

authority of the clergy to regulate usury, and with it, trade. Trade was also a political challenge for the clergy since the prosperity of the community as well as the church itself was dependent on trade. The church was in fact an important investor in trade since the inflow of money to central agencies of the church was considerable and those resources had to be used to strengthen the church. A bi-product of this participation in business was, evidently, that the church was well positioned to keep informed about the practices that were invented to avoid usury. We have mentioned the “double contract” (where the lender imposes a sale and an immediate repurchase of goods to secure the interest on a loan), the Jewish use of Gentiles as middlemen in transactions, and the Islamic use of legal experts to avoid usury in the eyes of the law (hiyal). There were many others. Before we go into some of these practices and their relation to the welfare of banking, we need to have a conception of what a business model (for a bank) is. We posit that it is within the framework of a business model that new practices were invented (or abstained from), and it was in connection with business model development that merchants and their banks posed new challenges to rule-making. A specific characteristic of a business model is that it is not only instrumental (the most profitable alternative) but also normative (maintains a “good name” in society). This is significant. Both the “how” and the “why”. Activities have to be efficient as well as justifiable. Detour on business models The Oxford Dictionary defines a business model as “A plan for the successful operation of a business, identifying sources of revenue, the intended customer base, products, and details of financing.” Like all conceptions – this phenomenon should be understood as part of the practical world, and as such it is a concept given meaning in context – an interpretation of what it means to conduct successful business here and now, in this particular context. That means that a business model should be expected to be geared to a certain environment and change with it, and over time. The business model prescribes what the organizations should do given this or that condition, but, possibly more importantly, directs the awareness of members to watch out for certain phenomena that are considered important. Sometimes it is said that organizations cannot “do” anything, only individuals “do” (Cyert & March 1963), but in real life – in practice – we see organizations do things all the time: Congress adopted a new tax law, Manchester City played well and won, Microsoft has released a new update of Word. The business model includes obligations for what individual members of an organization should do (for the good of the organization) in certain circumstances, and, thus, has normative as well as instrumental sides. You qualify as a member of the organization by, among other things, contributing to its production in

34

Community as centre of authority

alignment with the role it gives you. In other words, the principles contained in the business model are given normative power by your will to live up to the identity it gives you in the organization. Membership work – your efforts to maintain your status as a member – includes aligning your action with the intentionality of the business model (in context). Intentionality (Searle 1983), means mindful goal-directedness as well as attention-focusing on that part of operations that your role identifies. What this means in a concrete situation is open to judgement, by yourself as well as by other members who may be concerned about your worth as member. The principles of a business model provide opportunities to calibrate action, criteria of relevance, as well as a basis for good arguments. It follows that the business model is a multidimensional construction with many links, and open receptors to the environment. This makes it adaptable to as well as dependent on context. To describe the business model of a particular organization in a particular context is not easy, even to the members themselves. It serves as an interpretive tool as well as constructor of duties and concerted action. Many organizations have collections of the principles in small booklets called something like “Our Ways”. Still, if you read such a text, it comes across as very abstract (and propagandistic) – to the extent that it works for the organization it is contained in “lived experience”. You can find out about it by observing action by members and their justifications (Boltanski 2009; Scanlon 2014) for action. Let us try to describe the business model of a major bank that can be expected to know what they are doing (top 100 in the world, managed well through the 2008 crisis, more than 150 years old), which we have mapped with the help of a large number of interviews with top, regional and branch managers over a large number of years (but without access to its business model booklet). At the core of the business model is “personal responsibility”, which assumes its significance by being embedded in practices. The design of the credit process, still the core business of most banks, stresses personal responsibility in that no credits are granted unless they have been approved by the branch receiving the loan application. No CEO of a large corporation can approach the bank’s top management directly for a loan, everything goes through the branch office in charge, which does the first review of the loan application to the branch. When the branch manager has evaluated the application, he or she writes a credit PM with reasons for his/her recommendation (if the recommendation is “no” the matter does not go further than to the Regional office). At the Regional office the credit PM is read and questions might be asked, but the regional office cannot override the branch. There are limits as to how large credits can be granted at the branch, region, HQ, of course, but all applications have to be approved from the branch up. The credit PM is reviewed every quarter, with new text added if necessary (more frequently if there are signs of an emerging crisis). When the implementation of Basel II required banks to have an internal (quantitative) rating system for credits this justified that the credit PMs had to include the internal credit ratings, which in turn could be used to provide the branches with a risk adapted internal price for capital. (Top

Community as centre of authority

35

management claims that this internal price of capital is, thus, based on risk and allows branches to do risk-adjusted calculations on the individual loan). Any temptation to over-rate the creditworthiness of a client would be countered in the dialogue with regional offices asking for justifications. The personnel policy of this bank is built on life time employment and couched career management. Branch managers are encouraged to recommend their best co-workers to be moved to suitable complementing experience. “It will give me a nice internal network” a branch manager responded to a question about losing talent to other parts of the organization. A profit-sharing fund has been in place for a long while, where half of the surplus return, in comparison with competitors, is funded for payment at retirement. This employee-fund is the second-largest shareholder, and employees have had two representatives on the board for more than 40 years. The bank competes successfully in mature markets like the UK due to its low C/I ratio. Its competitive power seems to come from its consistent low rate of credit loss costs, which, in turn, can be related to the use of “local” information by branch managers responsible for the credit (early warnings). We find many managerial principles in use that relate to this personal responsibility tenet. Employees see that top management is serious about this in action and stay on until retirement in impressive proportions compared to other banks. The point of giving this small account is to show that a business model that works well hangs together to constitute “our way” of doing business to an extent that promotes personal responsibility (mindfulness), steady growth, and resilience in crises. This constellation of principles forms a conception of the business model that works in practice. It is not an academic concept designed for analytical purposes. It emerges through practice as a guide to members’ judgement, awareness as well as concerning “what-to-do”. The problem, at least as far as banks go, is to discover when it is time to “short-circuit” the current business model, to switch from a “normal” mode of operation to “crisis” management. This would imply the application of the most basic/fundamental principles to the changing context to work out a new path ahead, which will, in time, be confirmed by initial success (Jönsson & Lundin 1977). This conception of the business model phenomenon will guide us in the following case studies where individual banks’ navigation in a changing environment is tracked. But watch out! The cases have been chosen on the basis that the banks in question failed.

2:5 Three cases of bank failures in late Medieval Europe 2:5:1 Case 1. Bills of exchange and the Medici bank Bills of exchange The increased use of this financial instrument originated, according to de Roover (1963), in the need to evade usury laws in the late 13th century (but

36

Community as centre of authority

also because a piece of paper is less attractive to pirates than a chest of gold coin). It served to disguise the interest rate (usury) within stated exchange rates, which were (artificially?) held high to favour the ‘lender’ (Florins rated high in Florence, while the pound was rated high in London – an arbitrage situation). In his famous thesis, Raymond de Roover (1963) showed how the Bill of Exchange effectively achieved this objective. The Bill of Exchange was simply a letter containing an agreement between two merchants, one, in city A, instructing his agent in city B to pay a certain amount of money (say Florins) to the bearer of the letter, say three months after the date of the letter (three months being the expected time to travel by ship from London to Florence). The exchange rate between the Pound and the Florin would be determined by the merchants making the deal in city A (say London). The agent in city B could then, if it was a loan that was to be repaid, send the money received back to the originator in city A by a similar Bill of Exchange. Mostly the bills of exchange constituted payment in trade deals, but there were also examples of “cambio secco” (dry exchange) with no underlying exchange of goods. The Church did not mind as long as the rates of exchange were determined in advance. The Bill of Exchange was not only a loan in disguise but a relatively safe way of sending money between distant cities (the pirate boarding the ship would find just paper). The drawback was that the Bill of Exchange did not have any standing in medieval courts. It was based on the “good name” of the signatures, and on the presence of other merchants to cash bills at the destination. During the 14th century the Hundred Years’ War raged in Europe. The difficulties of financing such prolonged warfare generated fiscal solutions where precious metals had to be delivered to the prince’s mint, and on a ban on exporting such goods. This policy is called “bullionism” (Munro 2001, p. 52). Counterfeit coins appeared, which led to a ban on importing foreign coins (in Britain). One effect of bullionism was that deposit-taking banks disappeared before the end of the 15th century, only slowly to re-emerge in Antwerp and Amsterdam in the coming centuries. The Bill of Exchange instrument could obviate these regulations. (It seems like goldsmiths (of London) found opportunities to trade in bullion under this rule, some of them becoming fully fledged “modern” bankers (Munro 2001, p. 60)). A transforming process of making bills of exchange negotiable started, i.e., a secondary market emerged. In 1537 legislation in Netherlands recognized bearer bills, and later an added ordinance permitted interest payment (up to 12%). By the mid 1600s interest rates had come down and the State could borrow on bonds that were bought voluntarily at 4–5%, much cheaper than in other countries. The main factor was the existence of a lively secondary market for the different financial instruments in Amsterdam. By 1666 the courts of Britain followed suit. Now the stage was set for a permanent national debt based in interest bearing loans. England surpassed Holland (where the Wisselbank van Amsterdam distributed loans on a national level) in a financial revolution where the new Bank of England provided a loan to the State, which was financed by an issue of stock at the end of the 17th century. Similar loans to the State were provided by the

Community as centre of authority

37

East India Company, the New East India Company and the South Sea Company (to secure monopoly rights) in the following years. Now imperialism, bringing home valuable goods from overseas under the auspices of mercantilism, was on the agenda. The State was in control, but the landed gentry, merchants, and modernists were in control of the State. Trade generated huge fortunes, and those who wanted to avoid the adventures of sea-faring could focus on investment in financial instruments related to trade. An era of merchant banks, to a large part located in London, had opened up after Britain’s victory over Holland in the contest of who would rule the waves. Merchant banks all started as merchant houses, but by the time London became the centre of finance these banks had largely abandoned the tedious job of dealing with the goods (warehouses, transportation, etc.) and occupied themselves only with financial instruments. The bills of exchange had been the main tool for creating a secondary market and a new vibrant banking sector dominated by merchant banks in financial centres. The rise and fall of the Medici bank The classical description of the Medici bank by de Roover (1963) starts from an account of the money market (bills of exchange) at the time, but also includes the Medici as merchants (alum and iron), and as industrialists (wool and silk), as well as bankers to the Pope. From the Crusades to the Great Discoveries, Italy was the dominant economic power in the western world. Merchants were the middlemen of spices from the Levant, silk, cloth, wool. Banking prospered with trade since the transfer of payment for goods was best accomplished through bills of exchange (transporting money over land or sea was risky) and there was gain to be had from the differences in exchange rates. In bank-dense Florence and some other centres there even was a secondary market for such instruments. The trade activities were to a large extent organized as partnerships (the Medici bank was organized as a holding company, with partnerships at the branch offices). Double entry book-keeping was practiced, the beginnings of what could be seen as insurance for marine transports (sea-loans), and a body of mercantile law were developing. A Florentine merchant house was a global business with as many as 90 employees in branches across Europe. The Medici bank is remarkable because of its good archive up to 1450. To avoid the wrath of the Church the Medici bank focused on bills of exchange. The close connection to an unbalanced trade from Italy to Northern Europe, plus the flow of payments to the Vatican, was a constant problem for the bank. As bankers, Medici had to be members of the Money-changers’ Guild, but de Roover notes that the regulatory power of the Guild was rather limited and it did not interfere much in daily business. There was a direct tax in Florence based on individual tax returns (catasto), which provided a strong incentive against overvaluation of assets.

38

Community as centre of authority

Like many of its competitors the Medici bank had branches in many centres of commerce across Europa. From a modest beginning in Italy (branches in Florence, Rome, Naples, Venice) in the early 1400s it expanded to 13 businesses in 1450 (branches in Ancona, Avignon, Basel, Bruges, London (subordinated to Bruges), Florence, Geneva, Pisa, Rome, Venice, and in addition wool shops 1 and 2, and a silk shop in Florence). The executive managers of the different branches were usually co-owners, and their duties were regulated in detail in management contracts for up to five years (which could be terminated by the principals (maggiori) at any time). It was quite common that the branch managers had a share in profits (and losses) that was substantially larger than their ownership share. A “factor” was a manager who was authorized to enter binding deals for the firm. It was not the signature alone, but the whole text of a Bill of Exchange, that had to be written in the factor’s hand to make it valid. A factor could be promoted to partner (invest his own money in the branch) and employees were groomed by being sent to different branches to learn the business. Employment was closely monitored by the principals and was largely based on family and trust (and double-entry book-keeping). The legendary original leader, Cosimo, was not sentimental about dismissing nonperforming managers, but his successors seem to have been too tolerant for the good of the firm, which contributed to the fall of the bank. In cities where Medici had no branch of their own they did business through representatives or silent partnerships. The Rome branch was somewhat different from the other branches in that it was run without capital. This was a result of the flow of funds in this century, inward toward the Pope, and of the fact that members of the Vatican court deposited money with the bank (against other kinds of remuneration than interest, of course). For the bills of exchange business to function smoothly there had to be a money market that could liquidate such instruments (and provide for some trade credit). The power of the Italian banks in Europe came from this money market effect – there were several dozens of banks in Florence at the time. The Hansa League had, according to de Roover (1963), a much clumsier and slower way of dealing with payments and could not compete in Western Europe (except, perhaps, in London). Trade was the very reason for doing banking business. As mentioned, Medici had two wool shops and one silk shop during most of its lifetime. One could see that good management made a difference by comparing the two wool shops in Florence. The best wool was imported from Britain, which was difficult business since the King of England would control the trade and collect custom fees (or borrow money on the promise for the lender to collect fees during a certain period). The Medicis also had trade in materials like alum, which was used to clean wool. However, contracts with the Pope to secure monopoly in providing alum (sometimes threatened by the Turks) did not work out so well. Political games were frequent around trade. During Cosimo’s reign the Medici policy was to avoid lending money to princes,1 or to the

Community as centre of authority

39

crown (the State as it were), because princes often had no intention of repaying. Still, Cosimo was not foreign to using his financial resources politically. He even avoided a death sentence by bribes, but was expelled from Florence in 1433 – when his enemy Rinaldo degli Albizzi had him arrested and argued for execution – only to be called back a year later. Florence was involved in complex and shifting alliances and wars at the time (Machiavelli 1513/2010). The most dramatic business event, and one reason for the decline of the bank, was possibly the ill-conceived strategies of its representative in Bruges, Portinari (who had intrigued his way to the top there). The issue of appointing Portinari to manager in Bruges came up in 1464, the year Cosimo died. The contract with him was written by Piero (Cosimo’s elder son) in 1465. Both of them (Cosimo and Piero) hesitated because they considered Pontiari too reckless in business. The money market in Bruges worked well due to the presence of several Italian bankers, but the wool trade was volatile due to the conflict between the Duke of Burgundy and the English King; Portinari’s acquisition of the right to collect toll on the wool import turned out to be a mistake (the King stopped the flow to be taxed), as was the purchase of surplus galleys (now that the crusade against the Turks was called off due to the death of the Pope (Pius II)). There simply was not enough cargo to occupy the galleys profitably. Bruges and its relation to London became a constant problem to the maggiori (principals). Piero, Cosimo’s son, had been trained in politics rather than banking. Machiavelli (1513/2010) claims that Piero caused discontent and many business failures by calling many outstanding loans to be repaid in order to improve the balance sheet. De Roover (1963) points out that the truth of the matter was that Piero, when assuming the role of principal, initiated an audit to see what state the business was in, and that this audit revealed that the bank was in poor condition. He therefore took steps to close down the Venice branch that was unprofitable, and he sent his associate Tani to try to solve the London problem by negotiating a deal with the King, Edward IV. He also ordered the Milan branch to reduce its loans to the Sforza court. Still de Roover maintains that it is doubtful whether the retrenchment of the Medici bank was the cause of “the epidemic of bankruptcies which broke out in Florence shortly after Cosimo’s death” (1963, p. 359). It was rather that many of the firms that went bankrupt had business commitments in the Levant, which were cut off with the war between Venice and the Sultan between 1463 and 1479. There was more to come! Piero had died in 1469 and was succeeded by his sons Lorenzo and Giuliano, 21 and 18 years of age, who necessarily became dependent on their father’s advisors. Lorenzo soon developed into a gifted politician, but he was not interested in banking. He relied completely on Francesco Sassetti, a long-term employee, who became the real manager at the headquarters. Due to Sassetti’s policy of allowing branch managers too much room for extravagant manoeuvres, the “maggiori” lost control of the Medici group and mismanagement in some branches was allowed to go on for too long. The Bruges branch and its manager, Portinari, has been mentioned above. His brother Pigello was not much better as manager in Milan, since he

40

Community as centre of authority

got entangled in ever increasing loans to the Sforza court. Another cause of decline was the Lyon debacle of Lionetto de’ Rossi. Up to 1463 the leading trade fair for merchants had been Geneva, but that year the French king, Louis XI, issued a decree that exempted all merchants that came to Lyon from toll duties. This turned out to be an effective incentive. Medici’s Geneva branch moved to Lyon in 1466 in order to be where the business was. The name of the branch became Francesco Sassetti & Co (although the Medici provided 66% of the capital). At first the Lyons branch was successful, but soon its first branch manager was expelled from France (for supporting enemies of the King). The second manager died within a year, and the third manager, appointed in 1470, was the infamous Lionetto de’ Rossi, who had been a factor with the branch (first in Geneva and then in Lyon) since 1453. The first sign of a problem appeared in 1476 when headquarters complained that the balance sheet submitted by Rossi was “too full of slow debtors and stocks of merchandise”. An intervention from Leonardo made Rossi promise to mend his ways, but soon, by 1480, the balance sheet showed a loss and Medici’s agent in Montpellier (Lorenzo Spinelli) was sent to investigate. Rossi did not like Spinelli’s spying on him. In 1482 Rossi sent two balance sheets, one to Sassetti, and one to Lorenzo (Medici), (this one with lots of explaining text). Rossi claimed that business had picked up and the future looked bright. He had managed to collect a lot of bad debts and build reserves. The letter to Lorenzo contained a number of accusations against Sassetti. The real problem, however, was that Rossi had come into the habit of drawing on the Rome branch for payments but failed to remit promptly. Rome complained and finally refused to honour a draft by a French merchant on the Lyon branch. Another set of accounts sent in 1484 claimed that the Lyon branch was now free of bad debts and generated a profit. Spinelli was sent to investigate again and found Rossi “out of his senses”. Lorenzo, trying to mediate, called Rossi to Florence for a conference. Rossi took his time to set out on the trip. When he arrived, months after being called, he was put in the debtors’ jail. An audit of the books showed manipulation and a frightening loss. Spinelli was persuaded to take over and clear things up, which was a formidable task since headquarters were slow to provide fresh capital at the same time as they insisted on reducing debt. Turnaround by entrenchment is not an easy task in banking. Sassetti (who had a son at the Lyon branch) promised to stay on as manager at headquarters until the mess was cleared up. He visited the branch from May 1488 and found improvement and helped restore confidence. A new management contract was set up in February 1489. Both Sassetti and Lorenzo de Medici died soon after this, and the entire Lyon branch was expelled from France as a result of new hostilities between the French King and Florence. After the King had failed to win the war, Spinelli and staff returned to Lyon, but were unable to run a profitable business without capital. This illustrates how difficult it is recover trust in a, basically, hostile environment. Lorenzo Medici devoted his energy to try to save the bank from 1478 until 1494 when the Medici rule of the City of Florence was overthrown, and all Medici property seized. The Medici bank, without capital soon perished.

Community as centre of authority

41

It should be mentioned, to illustrate business conditions of the time, that the Pazzi bank, probably the second largest bank in Florence, saw what trouble the Medici bank was in. Was it heading toward bankruptcy on its own or did it need a push? The Pazzi conspiracy was based in the idea that by toppling the bank one could also remove the Medicis from political power. There was an attempt to assassinate the two Medici brothers (Lorenzo and Giuliano) in a church in April 1478. Giuliano was murdered but Lorenzo escaped with his life. It might be claimed that politics as well as lack of internal loyalty, not only bad business decisions in Bruges, etc., killed the Medici bank. It simply was unable to uphold all its external and internal relations to keep its good name. The Medici business model One must keep in mind that the Medici was a trading house with banking as a supplementary activity. The Medici bank, at its best, was run on trust and good book-keeping with trusted branches given much leeway during the growth period under Cosimo. Growth was incentivized by the agents’ participation in the capital of the branch, and profit-sharing contracts. Cosimo was a strongwilled and watchful “maggiore”. He had a co-manager (Benci) who matched him in diligence. Lorenzo de Medici had a co-manager too (Sassetti), but did not pay much attention to banking during the first decade of his reign. When the centre was weakened (and local contexts got more dynamic) local risk-taking by branches brought the bank down (cheating in accounting delayed corrections). A key to success for Cosimo seems to have been his careful selection of trusted branch managers and a watchful central eye on branch performance. One must remember that although Medici was a multinational company it remained fairly small in the number of employees. The decline was driven by local agents’ immersion in local political opportunism, and bad judgement in deal making. The central control system could not sustain “control at a distance” under the shifting, local circumstances, so much the more as agents betrayed trust by entering into local deals with high risk. A business model based on trust in a bills-of-exchange community could not match the turbulence of local politics when the HQ capacity declined. Occasional visits could not compensate. One should also note that the power of double-entry book-keeping comes from a diligent principal and frequent auditing. That is why Cosimo was in control to the end of his life, and also why things degenerated under his heirs (who shifted attention to politics). 2:5:2 Case 2. Fugger and the rentes Rentes Governments, local, regional or national, could not function without some kind of loan in medieval times. This was because tax and rent collection was

42

Community as centre of authority

not very effective, the aristocracy was exempt from paying taxes, and princes were frequently involved in costly wars. “Forced loans” (loans taken at “gun point”) were common. The cities of Genoa and Venice were early in relying on more permanent debt solutions, in the 12th century, by granting a consortium of civic lenders control over tax revenue funds (outsourcing) to reimburse lenders. In time, Venice consolidated its various debts, decreed that debt-holders would receive an annual interest of 5% paid twice a year, and by the beginning of the 1300s a secondary market for the Venice debt had developed. Florence set up a similar consolidated debt fund in the 1340s consisting of mostly forced loans to pay 5% annually to debt holders. The frequent forced loans were justified by the duty for all citizens to contribute their “fair share” of income to the city state (preferred to taxation because there was compensation in the form of interest). Interestingly, the very fact that the loans were forced (a duty) allowed both theologians and jurists to argue that it was acceptable to pay and receive interest. The secondary market for such debt, being free, often “forced” the sellers to accept large discounts to find buyers. Theologians now argued that such buyers of debt had not become (dutiful) lenders to the state but were engaged in usurious activities (“parasites sucking the life blood of the state” (Munro 2001, p. 22)). The moral qualms about lending money against interest still remaining, some European free cities had engaged in a less problematic practice called rentes. It stemmed from the practice of many monasteries of using the Carolingian census contract to acquire bequests of land. The donor of land to the church would, with such a contract, receive an annual “usufruct” income from that land for the rest of his life (and sometimes for the life of heirs as well). This income was not usurious since it was the fruit of the property. This kind of “loan” came to be called rentes (English: annuity). Two versions evolved; one was the sale of property against a promise to receive a perpetual annual income, the other was that the property holder sold the right to an annual income from the property but remained the owner of that property (cf. leasing). These also became instruments for merchants and others to invest in agriculture. When rentes became instruments for public financing of city governments they appeared as lijfrenten in Dutch/ Flemish towns (also in hereditary forms). The first to adopt these forms of renten to finance public debt were towns (that had a corporate status vis-à-vis the State) in Northern France. But the risk of being subjected to investigation by the Church for usurious conduct was still there. Theologians claimed that the buyer of census contracts was in usurious conduct. In time, the lead argument tended to become that the lender (or purchaser) of these contracts could not ever count on the principal being paid back – therefore it was not a loan, and, consequently, no usury. By 1416 the Council of Constance declared rentes contracts licit and débirentier (the payer of rentes according to such contracts) had the right to redeem the contract (provided that it did not include any reduction in nominal capital value). This was later confirmed in three papal bullas. Now city governments

Community as centre of authority

43

could transform short term debt to long term by issuing rentes contracts without risking repercussions from church intervention, and Northern France, Flemish and Brabant cities could develop secondary markets and, thus, become centres of finance. The principle that the borrower could pay back the rentes contract at any time was confirmed by Imperial Habsburg edicts in the 1500s. In 1522 the French Royal chancellor established Europe’s first publicly funded and permanent national debt based on rentes (Munro 2001, p. 41). However, there was no secondary market for these securities during the 16th and early 17th centuries, which tended to “lock investors in”. This, together with the frequent failures of princes to honour the annual payments, forced rentiers, who, for various reasons, had to liquidate their contract, to accept prices lower than half the face value of the contract. The institutional structure to secure a smooth working of this quite useful financial instrument for public debt was not yet in place. That would have required a State apparatus (a bureaucracy) bound by the rule of law. Princes at this time, as we know, held their position by Divine Right. The financial innovation to use rentes contracts to finance national debt was probably first used in Spain as Ferdinand and Isabella sold juros de heredad (heritage juros) in 1489 to finance the war with Granada that led to the unification of Castile and Aragon in 1492 (Munro 2001, p. 48). Problems with this practice arose since Philip II had forced short term debt (asientos) to be converted to juros al quittar (perpetual at, say, 5%, but still negotiable) as he declared “bankruptcy” (postponed payments) in 1557, 1575, and 1596, whereby he violated his obligations toward creditors. The Spanish government managed, in time, to pay the rentes even if it became a financial burden (75% of the tax revenues by 1584). But many banks could not cope with the strain on liquidity. The key factor in the success of the Spanish juros across Europe, as well as the rentes in Habsburg Netherlands, is the development of a secondary market that made these investment vehicles reasonably liquid. This was primarily due to the foundation of the Antwerp Bourse in 1531. Trading (legally sanctioned) in juros and rentes in Antwerp became the main activities of German banks, like Fugger. The Fugger bank The successor to Medici as, arguably, the most prominent bank in Europe, seems to have been Fugger of Augsburg. This family had a different business model from its start in that quite early it focused on lending to kings and governments, extracting in return interests in the form of contracted cash flows from mining (or even managing rights for mines) and farming, primarily from the Habsburg family of kings and princes. The Fugger banking business was more or less dismantled after a drawn-out decline at the end of the Thirty Years’ War (ending with the peace treaty of Westphalia in 1648). Ehrenberg (1928) finds it necessary to give an account of the different kinds of credits that existed in order to give a proper view of the fortunes of the Fugger family and its problems, chiefly stemming from their strong commitment to

44

Community as centre of authority

support the Habsburg princes and their wars. It is necessary to gain some insight into the intricacies of public debt (nowadays known as “sovereign” debt) to see how Fugger got entangled. A special creditworthiness attached to the free cities at the time since their citizens could be called upon to pay if the city failed. At the other end of the scale were princes, who, with their longing for glory and war, usually never intended to pay back. Instead they tended to threaten that if the creditor did not extend further credit the existing credit would be lost, or the matter could be solved in other ways, by “forced loans”, as the prince’s representatives arrived at the doorstep and helped themselves to a credit and left an IOU note. A contract was set up with the creditor to receive payment via the income from estates, mines, tax collection over a certain period. The problem with this “farming out” of income streams was that the creditor often did not know to what extent they had already been mortgaged. One had to try to keep well informed and to maintain the goodwill of the prince so that one’s contract could receive preferential treatment (“senior debt”, as it were) if the prince’s cash happened to be scarce at the time of maturity. And one had to be well informed about developments at the court, which required a constant presence. It was the wars – particularly the payment of soldiers, who would ransack the place where they happened to be if contracted pay failed or go over to the other side – that drained the princes’ coffers. No prince could afford to keep permanent forces of any size, so mercenary solders were hired periodically. This made princes rather desperate for cash at times. Cities and their guilds were common targets for extracting cash for war. Merchants had shown the way by using financial instruments to have access to cash in places like Antwerp or Bruges. Guilds were stable organizations to deal with. The Church with its steady cash flow, in spite of its preaching against usury, was a frequent business partner to merchants, making deals that contained a great many synonyms for interest. The Fugger house was brought down by committing too much of its resources to sovereign debt. Ehrenberg (1928) gives a short version of all the complexities of the greatest bank of the 16th century: The first Fugger, Hans, came to Augsburg in 1367. He was a weaver, but also did some trading. Soon after his arrival the Guilds of Augsburg obtained a share of the management of the city. The two most prominent guilds, the Weavers and the Merchants, prospered from this. Hans also did well and left his two sons, Jakob and Andreas, in a good position. Jakob was already Master of the Weavers’ Guild when Hans died, although he had given up weaving. The Fugger trade was, like that of other Augsburg merchants, oriented toward Venice (spices, silk and woollen materials). Andreas did even better than Jacob, marrying into an old family to start his own branch, Fugger vom Reh, which prospered and expanded into links with the Netherlands and Leipzig. The Fugger vom Reh, however, soon lost heavily on bad debts, sunk further in respect, and had, in time, to seek employment with their cousins, the Fugger of the Lilies. The more modest son, Jakob, married the daughter of the Master of

Community as centre of authority

45

the Augsburg Mint. He managed to fend off the imminent bankruptcy of his father-in-law (the Mint Master) by guaranteeing his debt. The father-in-law was now able to make a come-back as Master of Mint, this time in Hall, not far from Innsbruck. Thereby Jakob found connections with the Tyrol mining industry. Jakob’s son, Jakob II, was sent for training to merchants in Venice at the age of 14 (even though he had first been intended for the church). He conducted business together with his two surviving uncles and they reached an agreement between themselves that their male heirs and descendants should leave property in common (equity) in the business in order to keep it intact, but that daughters should be given money in dowries. This principle was adhered to as long as the Fugger house prospered. (It was given up, however, after the house suffered losses on bad debts in connection with the war of Schmalkalden (1546–1547).) Even if Ulrich Fugger had a successful business deal with the Emperor (Fredrick III) to provide silk and clothing for his son Maximilian as he went to Trier to negotiate a marriage in 1473, it was Jakob II who set the Fugger house on course to success in 1487. He lent money to the Archduke of Tyrol against security in Tyrol silver mines. A still larger loan the next year established Fugger in the mining business. Copper was added in a similar manner, and syndicates were formed to control the copper market in Venice, and shipping organized via Danzig to Antwerp. As the Archduke of Tyrol handed over the government of Tyrol to Maximilian I in 1490, the stage was set for intensified financial relations between the Habsburgs and the Fugger house. This relation developed over the years and consisted chiefly in Fugger giving loans to the Habsburg princes and Emperors against security in farmland, mines, and cash flows. This, of course, provided opportunities for trade, which was the main occupation of the house. The relations between King Maximilian I and the merchants in Augsburg were quite strained at times, and the King considered resorting to “forced loans” but negotiations led to a large (voluntary) loan, most of it carried by Fugger. The situation grew even more complicated as the merchants (and some cities) were targeted for credits again and again. They often had to borrow themselves to muster the cash required. Fugger also served as an intermediary for English subsidies to Maximilian. Fugger also had complex business relations with the Vatican. The branch in Rome served several “princes of the church” with contracts carefully avoiding the word “interest”. For instance, they helped the new Archbishop of Brandenburg, Albrecht, with a loan to pay (bribe) the Vatican to win his appointment. Fugger was also active in the transfer of money (e.g., redemption payments) from parishes to the Pope. The most complex business at this time (1517), no doubt, was supporting the election of Charles V as Holy Roman Emperor. Charles was heir to three dynasties, Habsburg (Austria), Valois-Burgundy (Burgundian Netherlands and Franche-Comté), and Trastámara (Castile and Aragon). To win the election a large number of electors needed to be persuaded by money transfers, which

46

Community as centre of authority

drained the cash from Fugger, who had built a strong relation with Charles, via transfers from Antwerp to Madrid. With Charles V as King of Spain the strain on the finances of Fugger continued as Charles had difficulties to extract money taxing the Spanish people in order to repay loans. Furthermore, the counter-reformation (to combat the proliferation of Protestantism; Luther had nailed his theses in 1517) was managed from Spain as Loyola launched his Jesuit mission to re-conquer the souls of Europe. Possibly, the worst consequence of the election, however, was that Charles gained a strong enemy in his, then, competitor for the post, King Francis of France (Bourbon). The complexity of the Fugger business was now overwhelming. Jacob Fugger died in 1526, after having run the company since 1511, and nominated Anton Fugger as his successor in his will. Anton adopted a cautious policy the first few years. But as the threats from the Turks as well as the war with France ebbed and flowed the Fugger house found itself drawn into financing the Emperor’s wars again. In the 1530s the capital of the Fugger house stagnated. The period of the war of Schmalkalden (1546–1547) turned out to be the turning point for Fugger. In 1546 the Emperor had decided to make war on the Protestants and mobilized money for the purpose. The Protestants were defeated but the continued resistance from them could not be suppressed by force, and in 1555 the Peace of Augsburg officially recognized Protestantism as a legitimate religion. In the meantime, Fugger had, faithful to the Emperor, provided finance to the Catholic side. This upset other merchants in Augsburg, who were on the side of the Schmalkaldian League (the protestants). At this time (1547) letters show that Anton seriously considered giving up the Fugger business. Anton Fugger, in low spirits and poor health, had found that none of his nephews was willing to take over, so it was agreed to liquidate it all. This was not easy however; Anton says in his will (Ehrenberg 1928, p. 104): On account of long wars, matters have gone right heavily, so that not only are we unable to bring our own business to an end and collect the monies owing to us, but we have been constrained, in order to serve the Emperor and the King, to make fresh loans, ourselves borrowing money and getting into debt. Charles V was in financial trouble again, and had turned to Fugger in his desperate need. Fugger used the Antwerp money market to raise money to save Charles, further increasing already impaired debt. In October 1555, Charles handed over the Netherlands to his son Philip including untenable finances. Again, the Fugger house had to advance further loans through its agent Matthew Oertel, and to take over guarantees. In 1557 the Antwerp office went into crisis as King Philip ordered payments on government debt to be stopped. Oertel pleaded with the King pointing to all the years of faithful service. This came to nothing. Fugger’s decline started to accelerate. In 1560 Anton Fugger died leaving the business to Hans Jakob, and his three sons. Quarrel between

Community as centre of authority

47

the heirs, and mismanagement, did not help. The Spanish debt refused to come down. All that could be accomplished through three State bankruptcies for the Spanish Crown was a moratorium and promises of future payments (in view of the great services to the King). Still other Fugger business continued up to the middle of the 17th century. What remained then was large areas of farmland that had been devastated during the 30 Years’ War. Learning from Fugger It is difficult to understand how the Fugger house became so entrapped in (financially) unhappy relations with princes, especially the Habsburgs. How did it all begin? Why did they not stop? The decline of Fugger happened during the period building up to the 30 Years’ War. Researchers still disagree about the causes of that war (Steensgaard 1969/1970; Braudel 1977). At the time when it is generally said to have started, in 1618 with the “defenestration” of diplomats (throwing them out of the window of the Hradschin castle – miraculously they survived landing in a dung heap) in Prague, there had already been dispersed wars and conflicts for several decades, as princes and dukes tried to position themselves to gain from the conflict. The Fugger house lived through the prelude to this most devastating of wars (one-third of the population in Germany perished – the two World Wars did not come near that figure), and they must have seen what was coming, devoted as they were to serve the Emperor. Steensgaard (1969/1970) proposes that this war was driven by a process of building a State in many nations in parallel. It was the time of the formation of the “pre-modern state”. The old feudal system, with allegiance to the prince in return for protection, was giving way, over a century, to an administrative State (“rule of law”) with a bureaucracy effective enough to collect revenues from taxes and tolls, to support a costlier State (including standing armies). As creditor in such a context you needed to bet on the right horse. It was the merchants who could provide credit against contracted concessions, like the right to collect revenues from the silver mines in Tyrol, for, say, ten years. Credit for trade concessions from the State was under development as a strategy for merchant houses. But giving credit to princes still had the attached, considerable risk of credit loss. There was little in terms of safety nets except good relations. (Like Hobbes described; in the State of Nature – everybody’s fight against everybody – the right strategy is to seek peace in terms of good relations.) The Fugger case illustrates that princes are bad credit risks even if the “upside” is very tempting – and furthermore you tend to get stuck with them. The Fugger business model The banking business of Fugger was well connected to the physical processes of trade as it achieved greatness through its early connection with mining (Tyrol) and skill in harvesting the “fruits” of pledges for granted loans, like managing mines for a contracted period. Trading with Venice, not least in silk, created

48

Community as centre of authority

the opportunity to secure profitable relations with the Habsburg royal family. The impression is that Fugger let this orientation of “relational banking” grow into a dominating, and later captive, relation that caused its failure. It must have been tempting to take one step further again and again as mining in “the Indies” (after the Great Discoveries) generated shiploads of precious metal. Fugger could also see the growth in importance of the Netherlands part of the Habsburg realm, and the prospering of financial markets in Antwerp, Amsterdam, and Bruges, but could not cut the ties with the warrior Habsburgs, maybe because they were good Catholics in an Augsburg that became partly Protestant. In the end heirs could not be engaged to take on the immense task of reconstructing the business, and the inevitable conclusion was to wind it down. Again, one can see the difficulties of keeping free from the embrace of royal power, with its romantic and religious ties to the past. Several times the Fuggers were concerned with securing an equity buffer to maintain close control, which is difficult in an environment of “relational banking”. – Where should your loyalty be directed; the primary customer or the family firm? 2:5:3 Case 3. The Sevillian banks and the money supply The most interesting aspect of the failure of the banks of Seville is that it seems to depend, partly, on a too large an inflow of money from Latin-America. Too much money? An inflationary credit expansion coupled with “forced loans” to the King, who, gradually, lost control of important aspects of the colonies to Holland and England. The School of Salamanca – a development of scholasticism stimulated by the inflow of treasure from El Dorado Ideas developed by the School of Salamanca provide a background to the fate of the banks in Seville. When Grice-Hutchinson (2015) builds up her presentation of the background to the economic thought of the School of Salamanca she starts with the Greek influence, differentiating between the older scholastics that relied on the interpretation of holy texts, and the Doctors of Salamanca under Greek influence referring to reason. The Greek influence is impressive and long lasting – for example, the first five chapters of Adam Smith’s Wealth of Nations (1776) lay out the themes of Aristotelian views on market phenomena. This influence came to play a distinctive role in Spain coming out of Medieval times, as did the discovery of “the Indies”. One of the ways Greek teachings, notably Aristotle, came to Spain and from there to Western Christianity was by way of Arab authors, notably Averroes, who commented on Plato as well as Aristotle. His views of democracy deviated, however, from the anti-democratic teachings of Plato. He believed that an ideal State could be born out of democracy, but there were pitfalls (GriceHutchinson 2015, p. 70). The excessive quest for freedom in a democratic

Community as centre of authority

49

State leads to a man ruling himself as he wishes (self-interest) and, having no civic duties to perform, some people will turn into drones. But, since in a democracy, a man will be free to work as well as to be idle, there will be a class that seeks wealth alone. These people will serve to make honey for the drones. And there will be a third class who go about their business but are not property owners. The first and third class will plunder the money-making class and hate them. After this, either the only remaining active class will disappear, or its members will gain power and the State will become a tyranny. Averroes did not add much to the teachings of Aristotle, and rather made an omission. Aristotle, claimed that money is just a counting device in trade, pointing out that the Greek word for money (nomisma) was derived from nomos (law or custom), and that it is up to us to change the value of money. Averroes omitted this claim. He wrote in Arabic (while in Cordoba) and his texts were translated in large numbers into Hebrew and Latin, mostly in Toledo. From there his work came to penetrate Western Europe (after Averroes’ death in 1198). Aristotle’s Nicomachian Ethics, it should be noted, appeared in Oxford around 1250. The Greek thoughts about economics did not impress as much in Spain as they did in the rest of Europe. Still, the Church put up some resistance to the Aristotelian idea that value is determined by demand/need (subjective utility) with, for example, the bishop of Paris declaring the “averroeists” of the Paris faculty “heretic” since their teaching was based on the text of an Arab. Still, the new intensity of Aristotelian inspiration in the 13th and 14th centuries was followed by a second wave of commentary located in the School of Salamanca, developing what came to be a theory of value embedded in mercantilism. The energy in the new kind of scholasticism developed by the Doctors of Salamanca came, it seems, from the discovery of the Indies and the treasure shipped from there in large quantities. Business interests turned toward the new continent, while the King also conducted wars – not an ideal setting for banking. Grice-Hutchinson (2015) devotes Chapter 3 to the ideas of the Salamanca School and Chapter 4 to the economic context in Spain where the theory was developed. In the latter chapter she divides the 16th century into two periods, one of optimism (1500–1560) and one of disillusion (1560–1600). Even if there was a significant bankruptcy before 1560, bank failures had serious consequences in the latter period. The School of Salamanca grows from the earlier doctrine of the scholastics (Paris etc.) with its basis for “just price” in the free contracting between individuals. But it soon became preoccupied with the market price in the meaning of “the common estimate” of many actors in the market. Some authors, e.g., Bernadino of Siena, had developed a utility theory of value, by introducing three components; raritas (scarcity), virtuoitas (ability to satisfy needs), complacibilitas (appealing to taste). (The “paradox of value” – the fact that absolute necessities like air and water have virtually no value – often appears in the reasoning.) A free market was the basic attitude, but in times of shortage it was justified to regulate prices of necessities, like bread. On the matter of the value

50

Community as centre of authority

of money John Burdian, the rector of the university of Paris had introduced the distinction between the material value of money (coins), the production of money by the State, and the need for money in the exchange of goods. A problem with this was, however, that bills of exchange were used to conceal usury, not least in the form of “dry exchange” (speculation in currency with no goods changing hands). Professor Cajetan of Bologna was an important reference for the School of Salamanca, because he argued that profit on exchange is licit if approved by “common custom” and because of his general statement that “money absent is always worth less than money present”. There was already a basis for a utility theory of value and money; it only had to be articulated. The risky business in El Dorado The School of Salamanca coincides with the discovery of “El Dorado”, which initiated a change of Spain from a poor country of subsistence farming to a rich country overflowing in daring projects, and inflation. Seville, the home port of the treasury fleet, became a magnet for merchants (Grice-Hutchinson 2015, p. 97 ff.) – a trade boom ensued. Prices increased (making export difficult – imagine a merchant trying desperately to buy cargo for the ship waiting for the return trip to America), agriculture had declined, “the nouveau riche”, those who had been lucky with their projects in El Dorado, tended to buy land and retire to their estates, perhaps living off rentes from loans to the king. As mentioned, the Habsburgs were engaged in wars. By 1650 the “Indian” trade had fallen almost completely into foreign hands (even if the South Sea Company had not yet been started by the British government (this happened in 1711). What had happened to the economy? Why was not everyone rich with all that gold coming in? Before looking at how the scholastics sought to explain the economic development in Spain, let us look at the adventures of the army captain Jose de Salinas in America, as described by Carmona et al. (2013), to get a feeling for what business practices were like in that colonial era. (The events took place in 1731–1735, but they are illustrative of the kind of risks involved.) Salinas had signed a contract with the South Sea Company (SSC) to take 408 slaves on foot from Buenos Aires (now in Argentina) to Potosi (now in Bolivia). He could sell them “en route” or at arrival in Potosi. He was tasked to keep books on his transactions. The South Sea Company was a British company that had been granted a monopoly on slave trade (Asiento) in SpanishAmerica as part of the Treaty of Utrecht 1713, against a commitment to meet the workforce demand in the whole area (and an Asiento dividend to the Spanish Crown that generated problems with accountability (Carmona et al. 2010)). The logistic problem was considerable; sail to West Africa, buy slaves, ship them to Latin America, and transport them over land to be sold where needed. The company did well, but was also the main actor in the first financial bubble in 1720 (“South Sea Bubble”, see Temin & Voth 2004).

Community as centre of authority

51

The destination for Salinas, Potosi, was the richest silver mine area in the world – Cerro Rico – the problem was that the use of African slaves as workforce in the mine was declining. Another problem was that it was far from Buenos Aires – 2,600 km. Salinas’ project was no doubt a risky one, he started in August 1731 and retuned in February 1735. The contract specified, among other things, how to estimate the need for escort soldiers, whom to ask for advice (Pater Francisco de Aguila, a Jesuit, and top company representative in the province of Paraguay – “if pater Francisco is departed or dead ask Pedro Navarro”), and that the slaves were to be fed mutton (not beef). The journey to Potosi took from August 1731 to February 1732; 38 male and 12 female slaves were lost on the way, and 11 male and 5 female ones sold. In compliance with his contract Salinas kept detailed notes on the events and costs along the road to Potosi where he arrived with 339 slaves, who were valued by SSC experts at 300 pesos per man and 500 per woman. While trying to sell the slaves Salinas had to account for boarding expenses. The sale went well initially (219 sold from February to October 1732), but then the market seemed to be saturated, only 32 slaves sold between November and March. Salinas turned negligent in his accounting and did not send any of the sales revenue to the SSC for a while. By April 1733 Salinas was required to report as prescribed in the contract. Salinas responded by demanding the fee, due in February but not paid by April, from SSC. He also claimed to have paid cash to the local representatives of the SSC, who were supposed to transfer the money to Buenos Aires, but this had obviously not happened. In the meantime, the SSC boss in Buenos Aires, Juan Brawn, had been replaced by Enrique Faure. Salinas’ record-keeping declined in detail and from April to October 1733 only 39 slaves could be sold. Now Salinas requested that he should be allowed to sell slaves, not on a cash basis as required by contract, but through barter deals. This would require more work in terms of selling barter goods, but on the other hand the cost of keeping slaves would decline, some sale on credit took place (with bad debt as a consequence). He concluded the slave sales by August 1734 and departed to Buenos Aires, assuming responsibility for the transport of the revenue in silver from the sales, which was not included in the contract, and filed his final accounts in April 1735 (sales amounted to 100,000 pesos). The new SSC director in Buenos Aires, Faure, was not satisfied with the accounts and questioned a number of items in court, with response from Salinas and counter arguments from SSC. The matter was settled with concessions for both sides and Salinas, who had planned to settle in Chile, could be on his way, with his family. This, possibly, was not a typical business deal in Latin America, but it gives an illustration to what a changed and changing context can mean for the parties involved. Carmona et al. (2013) could carry out this interesting study with the help of several well-kept archives on the Indies in Seville. The main scholars of Salamanca Let us return to the scholastic deliberations on economic development. This “second wave” of scholasticism (the School of Salamanca) was initiated by

52

Community as centre of authority

Francisco de Vitoria, who tried to reconcile the text-bound doctrine (centred on Thomas Aquinas’ Summa Theologica) with the varied economic and political problems of the day. There are, however, only lecture notes preserved from his teaching. One of the most influential authors was Domingo de Soto (died 1560), who, together with Martin de Azpilcueta, set the new trend with his De Justitia et Jure, which analysed many of the economic problems. He used much space to describe current business practices. Particularly important, says Grice-Hutchinson (2015), is his account of the relation between the Spanish and Flemish fairs, which constituted the main channel by which “American treasure flowed from Seville across the Pyrenees” (p. 100). Azpilcueta’s contribution was the first clear statement of a quantity theory of money, which has often been quoted by later scholars. Further articulation and development were carried out by Banez, de Mercado Garcia, and de Molina. The last scholar of eminence of the School of Salamanca was the Jesuit cardinal Juan de Lugo (1583–1660). The strong influence of the school of Salamanca lasted for more than 100 years and was propagated, of course, to the Netherlands. A common denominator for the “Doctors of Salamanca” was that they demonstrated a thorough knowledge of current business practices. The teachings of the School of Salamanca The School developed the theory of value to greater complexity (e.g., recognition that prices sometimes should be regulated), especially by stressing that the just price is generated by the “common estimate” of the market, not by the need of single individuals. De Lugo pointed out that this “common estimate” is done by “prudent men” – should there be numerous imprudent men present this must be taken into account. Money and banking The School of Salamanca re-confirms Aristotle’s doctrine of the multiple functions of money (medium of exchange, measure of value, store of value). The efforts of the school to reconcile the ideas of just price and the doctrine of usury took them to exchange values; if money is scarce in one place and abundant in another it is only fair that a person should be able to benefit from transferring money to the first place (de Soto 1996). Soon Azpilcueta (1556) took another step by complementing the scarcity/abundance (of money) reasoning with the idea of purchasing power (scarcity/abundance of goods to buy). By 1642 de Lugo could conclude that the supply and demand of money, as well as of goods, will interact to determine the extrinsic value of money, making exchange operations legitimate. Already Azpilcueta had claimed that the inflation in Spain was due to the inflow of treasures from America and thereby came a first formulation of a quantity theory of money (a claim later confirmed by Hamilton (1934) – there was indeed a correlation between the

Community as centre of authority

53

inflow and the “Price Revolution in Spain”). We have arrived at a mercantilist conception of money flows between nations. The Spanish ideas travelled throughout Europe, and the stage was set for “political economics”. The articulation of a mercantilist attitude to the problems of Spain happened gradually over the late 16th and the 17th centuries and amounted to a demand for a planning and interventionist State. An avalanche of texts on the economics of Spain and proposed remedies were published, part by a group of authors, collectively known as arbitristas. Grice-Hutchinson (2015, p. 148 ff.) compares them to Schumpeter’s (1954, ch.3) “Consultant Administrators and Pamphleteers” as they diagnosed what had gone wrong and suggested remedies over a long period from the beginning of the 17th century. To illustrate how difficult times were for banks there follows a description of the rise and decline of the Spanish economy at the time (following GriceHutchinson’s account). The period of optimism (1500–1560) was characterized by the settlement and exploitation of the “Indies”. Shipping goods from Spain to America yielded huge profits at the same time as gold and silver arrived in Seville. We can imagine the frenetic merchant eager to buy goods (at any price) in Spain to fill the next ship to America. Prices increased and foreign merchants arrived in large numbers. The King – a warrior – spent a lot of money in military enterprises (in France, against the Turks, and Protestants). First, he financed them by loans in the Netherlands and Italy, but soon he had to take his credits from Spain (Castile) as well. The taxes, alcabala, on nearly everything that was sold, pressured the producers toward not bringing goods to market. The clergy and noblemen (hidalgos) had age old exemptions from tax. On a large number of occasions, the King seized treasure (from America) on its way to private persons issuing juros (based on various income streams to the Treasury) as compensation. As a consequence, the State was in great debt, with many sources of income pledged to a growing class of rentiers. Luis Ortiz, who was comptroller of the Royal Finances, sent a memo to Philip II (King since 1556) complaining about the excessive exports to America; furthermore, leaders of many cities had a personal interest in keeping prices high, he argued. There was a need for a re-organization of Spanish Commerce, and a re-establishment of the old virtues of frugality and diligence. The period of Disillusion (1560–1600) starts from a situation where gold production remained stable but silver increased (from America). The disastrous finances of the Crown required new levies on the (poor) population. But also noblemen had to go into debt to pay property taxes, spending an increasing part of revenues on interest payments to local money-lenders. The increased number of migrant beggars occasioned the Cortes (the Parliament) to propose the establishment of hostels (workhouses) for these poor. The King, with still worse finances, had resorted to different “tricks” including declaring the Treasury bankrupt in 1557, 1575, and 1598 (suspending payments), and increasing the copper content in silver coins (the vellon). The economic and political decline was accompanied by a spiritual loss. The empire, favoured by

54

Community as centre of authority

God, was punished. For what? Bewilderment! Now was the time of the arbitristas (which should be translated to English as “projectors” according to GriceHutchinson – it literally means, as first used by Cervantes: “one who proffers advice to the Crown”), proposing measures to get rid of the debt that was crushing the whole country. The period of recession and decline (1600–1700) included a decline in the arrival of silver, from 1630. The arbitristas often used the same dialectical method of reasoning as the scholastics, but now we can also see a distinct use of economic facts and statistics. The solutions were built on reductions in the export of raw materials and on an increased export of manufactured goods; reform of the tax system (a single tax instead of the current multitude of sales taxes (alcabala), which cost dearly to collect (one author estimates the number of tax collectors at 100000, requiring payment, which left less than 10% of the revenues for the Crown)); reform of the currency (the vellon), and the formation of a single Spanish company to win back the colonial trade that had been lost to foreigners. No signs of a recovery appeared, however, until Spain had been unified (with Catalonia) and forced to adopt a measure of free trade by the Treaty of the Pyrenees (1659)) under the new Bourbon Kings. The new mercantilist ideology, with a planning, interventionist State, could now be articulated by authors such as Jeronomo de Uztariz (1724) and Bernardo de Ulloa (1740). The Sevillian banks Banks in Spain could be divided into different categories. There were “court banks” that dealt with the important transactions, usually involving the King, whom they charged higher interest than they paid on deposits. Due to the wars, the King could often not pay interest on time or return the principal as contracted. This uncertainty was a valid reason for charging higher interest. Traditionally economists have paid much more interest to this category of banks than they have done to local banks (called public (or deposit) banks), which quite often served the court banks with liquidity. These local banks were privately owned and operated on licence from local authorities. Foreigners were not allowed to start public banks. Fugger was a court bank in Spain. The Sevillian context Banking in Seville was coloured by the local circumstances. Quite often the arrival of the Latin-American fleets, transporting merchandise as well as precious metals, were subject to late arrival, which had a severe impact on the liquidity of banks in Seville. Also, the Crown as well as tax authorities could intervene to change the destiny of the merchandise (for example in 1523 and 1534) because poor state cash positions brought about seizure of the cargo. This, in turn, made it necessary for these banks to manage overdrafts for clients who had missed the planned arrival of goods. This could threaten the survival

Community as centre of authority

55

of the local banks as other clients would claim their deposits to carry over during the delay, generating “bank runs” with further decline of liquidity as a consequence. To compensate for the uncertainties stemming from State interventions on banking there was an aura of tolerance toward bank operations. It was, indeed, forbidden by law to send money to Latin-America as well as for banks to engage in trading, but the Crown showed some tolerance toward such activities. The rules for local banks included, as mentioned, that candidates had to apply for a licence from the city council with a related guarantee to be used in case of bankruptcy. The amount required as guarantee increased gradually over the 16th century due to the increased risk of bankruptcy. It was 50,000 ducats in 1519, and 204,000 in 1552 (Ruiz Martin 1969, Tortella & Ruiz, 2013). Such a guarantee was far from enough in comparison with the average deposits of four million ducats that came with the Latin-America treasure fleets’ arrival in Seville. The local government did not have any capacity to supervise how the banks functioned. There was no central bank to resort to if a bank found itself in trouble. This made the banks vulnerable to rumours. Sevillian public banks paid 7–7.5% interest rates on deposits. However, this was done “demurely” (recatadamente) to avoid interferences from the Catholic Church for usury. Along the same lines, and to avoid charges of usury, Sevillian banks engaged in active trading in bills of exchange. Another way of bypassing the usury norm was to let loans be denoted in cereals (e.g., wheat), or any other commodity, and, then, increases in the market price of wheat helped to pay interest. The public banks of Seville The number of public banks in Seville was small; there were four of them in 1545: Melchor de Espinosa, Juan Iñíguez, Domingo Lizarrazas and Franco Leardo. Tomás de Mercado (of the School of Salamanca) described them collectively: Seville bankers are treasurers and keep deposits of merchants. Once the fleet arrives in Seville, merchants bring to the bank everything coming from Indies. However, as the King used to run short of funding, he seized the cargo coming from America and banks usually had to repay the merchants from their own sources. (Mercado 1571, 381 f.) This was, obviously, a dynamic context where the banker was wise to “spread the risks”. In general, the business models would include:  

Contracts to collect (local) City Council taxes (almojarifazgo) Contracts to collect taxes for the King. This included paying in advance for the right to collect and then receiving periodically return payment by the King from taxes collected

56

Community as centre of authority



Providing guarantees for those who had contracts to collect taxes for the Royal Tax Authorities Taking private deposits (savings) against an interest of about 7% Managing payments from merchant accounts with the banks. (For such clients, the banks were valued on their “good name” or if they could provide a guarantee.) Engaging in trade with precious metals, like participating in auctions Providing guarantees for merchants that participated in such auctions (guarantees were a requirement for participation) Providing trade credit for merchants of Seville who traded in LatinAmerica, especially as the goods had arrived in port in Seville, but not yet sold Assisting “court banks” with transfers of money to the King Providing mortgage loans to local government Trading in State bonds (juros) Granting loans to farmers in a specific way (censos al quitar) where payment for the principal as well as interest was not in cash, but in quantities (cargas) of wheat Although it was formally forbidden, the public banks engaged in (lucrative) trading. This was risky since such trade usually was financed from the deposits of customers, so much the more as overdrafts were quite common, which could generate unexpected pressure on liquidity.

         

Two individual banks (Historical information on these banks is rich because they all bankrupted and, hence, their records were gathered by local authorities and kept in the archives): DOMINGO DE LIZARRAZAS

This bank was in operation already in 1542. One notable transaction took place in October 1546 when Domingo de Lizarrazas paid 6,375,000 maravedíes to Marques de Cáceres as a loan to Charles V in order to fund the ongoing war in Germany. The loan was granted by the city council of Seville and Lizarrazas was responsible for the money transfer. Lizarrazas had good relationships with Genoese bankers (e.g., Jerónimo and Gregorio Cattaneo), who became guarantors of Lizarrazas’ business on many occasions. As part of his partnership with the Genoese bankers, Lizarrazas engaged in financing land and maritime trading, with the exception of the Indies, since it was forbidden to send money there for licenced banks (Carande 1987). This bank engaged in contracting to collect public taxes. Lizarrazas paid a flat amount of money to the King for the right to collect and kept the resulting tax revenue (ibid.). He also engaged in transactions with gold and silver and held such deposits in the bank. There was regular fee income for professional services to partners, (like the Cattaneo brothers from Genoa).

Community as centre of authority

57

Regular bookkeeping provided profit and loss accounts that were forwarded to (minority) shareholders annually. In November 1552 Lizarrazas asked the City Council for an extension of his banking licence for four more years. He offered 86 guarantors, including four Genoese bankers, who guaranteed 22,000 ducats, that is, more than 10% of total guarantee (e.g., 204,000 ducats). The guarantee sum had increased significantly since 1545 when Lizarrazas had been asked to warrant 105,000 ducats. One must remember, though, that it was not uncommon for guarantors to declare themselves bankrupt to avoid having to pay out guaranteed amounts. The Lizarrazas bank was officially declared bankrupt on 11 March 1553. It was pushed into this situation by the delayed arrival of the Latin-American fleet in Seville. Lizarrazas had provided credit for people participating in the silver auctions at the Mint House in Seville. Due to the delay these loans remained unpaid. At the same time, Genoese merchants had been promised that 6,000,000 maravedies would be available at the Fair of Medina del Campo. When Lizarrazas failed to deliver they demanded 20,000 ducats in interest compensation. Further, he was engaged in trade with two galleons (which was illicit for banks), and in maritime trade with other shipping firms. He lost his “good name” by being unable to meet his obligations in several ways at the same time. This bankruptcy was quite significant for business and the society at large. As a consequence, a decree (Pragmática) issued on 6 June 1554 required bankers not to engage in risky business. It forbade them to grant loans with external money (i.e., fractional banking) and limited their activity to deposits and transfers. Furthermore, it was required that each bank had to have more than one owner, to further enhance its solvency. (This reflects quite literally the scholastic debate at the time.) PEDRO DE MORGA

After being engaged in business with Latin-American colonies (e.g., insurance), Pedro de Morga was granted a public banking licence in Seville in 1553. The bank specialized in funding operations related to slave trading and imports of dye from the Azores Islands, which was an important raw material for the Seville textile industry. The bank also funded agricultural operations under mortgage guarantees; as an example, in the case of Juan de la Torre, the guarantee consisted of the town of Velez de Benaudalla. Once de la Torre redeemed a portion of the loan, the yearly interest rate of the loan decreased from 9.09% to 7.14%. But when de la Torre sold the town to Gerónimo de Salamanca and did not pay Morga the remaining part of the loan from the proceeds, Pedro de Morga claimed the 9,831 ducats from Salamanca. Pedro de Morga was also deeply involved in business with the Catholic Church. The wealthy Sevillian churches used to hire high profile artists for their internal decoration. Such artists routinely received their compensation through Pedro de Morga’s bank. Furthermore, the Archbishop of Seville used

58

Community as centre of authority

the bank to transfer to the Crown taxes on the Subsidio and Excusado, which were taxes on income received by the Catholic Church. Business with the City Council was also important. Businessmen who had contracted tax collection with the local government used to deposit cash in public banks. This practice was an important source of income for Pedro de Morga’s bank. Alvarez Nogal (2017: 542) notes, in sum, that the bank was engaged in a wide variety of operations and became a well-known actor in Seville’s day-to-day life. The Fall Pedro de Morga bankrupted in 1576, right after the failure of its main competitor (e.g., Espinosa), amid the financial crisis of 1575, which was, in turn, caused by a royal decree. That royal decree, by Philip II, attempted to solve problems with the State’s poor cash position by withholding payments to its bankers (moratorium). The domino effect of this was a significant decrease in money supply caused by the intensification of the collection of public taxes to ameliorate the Court’s liquidity problems. According to several commentators, Philip II was quite aware of these effects of his Royal decree. A secondary motif for setting the crisis in motion was to diminish the power of local authorities. (Alvarez Nogal 2017) Alvarez Nogal (2017) argues, after having examined Morga’s accounting records, that the bankruptcy was largely caused by the bank’s close relationship with the “court banks” as well as its involvement in collecting State taxes. As the 1575 royal decree put on hold any royal payment to bankers, Morga’s liquidity was severely strained. The simultaneous crisis of Morga and Espinosa caused a financial collapse in Seville; merchants and businessmen could no longer pay their creditors. Right after Morga declaring bankruptcy, the local government confiscated its entire patrimony both in Seville and in Latin America (e.g., Panama). The Seville financial crisis also affected other trading centres (e.g., Burgos). In this way, the bankruptcies of Morga and Espinosa brought about insolvencies and bankruptcies of many Sevillian merchants who concentrated their business on South-American trade. All together the fate of the Sevillian banks was not a happy one. During the 1550s three main banks had bankrupted (Juan Leonardo (in 1552), Lizarrazas (in 1553), and Juan Iniguez (in 1553)). This caused the decree about avoiding risky business in 1554 (Pragmática). With the fall of Morga and Espinosa (in 1576) the King had had enough. From now on banking licences were no longer issued by the City Council (Cabildo), but by the King himself. (Although he, by tradition, was not foreign to confiscation of transports (esp. precious metals) from the Indies against juros (a document promising interest on the “forced loan”).) In general, the bankruptcy of Sevillian banks to a great degree could be attributed to their liquidity cycle: they engaged in long-term activities (trade contract for precious metals, loans to the Kingdom, farming loans) while their

Community as centre of authority

59

deposits generally had a short-term deadline. (Deposits were considered by many to be a matter of “safe keeping”.) Delays in South American fleets would then, for example, cause credits not be returned and interest not to be paid on time. This, in the end, brought about tough regulations, which established farreaching obstacles for the development of Spanish banking. Comment on the Seville banks case The banks of Seville lived in a tumultuous time, as the riches from El Dorado arrived and goods of all kinds were sent in return to build the New World. Opportunities multiplied as new merchants arrived and financial transactions increased in size and number. It must have been stressful to ponder which of the options on offer to pursue. Pedro de Morga seemed to have engaged in too many business ventures at the same time. Management capacity was not there to cope with all contingencies, not least the interventions from the King. This case also illustrates how the State gradually, often as a consequence of contingent decisions by central government, came to withdraw decision making privileges from local communities to bring them to the centre. Concerns centred around tax collection (still “outsourced”), credit financing (where the free cities played an important role, also concerning the development of financial instruments), and the building of a bureaucratic tradition with competent office holders. Thereby the centre of gravity of the social order had shifted toward “State (hierarchical control”). The State, in the case of the emerging overseas empires, had already chosen to develop the colonies by way of large monopoly companies, (The South Sea Company, albeit of British origin and established later is the most significant one). In this way huge fortunes could be transferred to partners in these companies, which in turn set the stage for the financing of the industrial revolution in Britain and elsewhere. In 1713 the enthusiasm for this form of exploitation had already gone so far that the Asiento treaty, granting the South Sea Company (started by the British government for this purpose in 1711) monopoly (for 30 years) for the slave trade to Spanish Latin-America (Carmona et al. 2010) was part of the Peace of Utrecht. It should be noted that the company failed to deliver the number of slaves stipulated in the treaty over the next 25 years (the South Sea Bubble happened in 1720). Furthermore, illicit trade involving South Sea Company ships was soon discovered (the “State” was not yet in control) and disputes led to several outbreaks of hostilities between Spain and Britain, which provide a “piquant” background to the accounting troubles captain Salinas (mentioned above) experienced in Buenos Aires in 1735. The tendency of moving the centre of gravity of the social order out of the hands of the State toward more of the Market was already in operation at the beginning of the 18th century, fired on by a policy debate about mercantilism combined with State bookkeeping of inflows and outflows of resources (see Soll 2014) When religion took hold of the people’s mind it was because of its basis in community. The communities were small and disaster and death were always

60

Community as centre of authority STATE “Hierarchical Control”

“Theory/Debate” / Principles

“Theory/Debate”

Medici Fugger

Practices Principles

Sevilla banks

MARKET “Dispersed competition”

COMMUNITY “Spontaneous Solidarity”

Figure 2.2 The social order centre of gravity moving from Community to State

present. The local rabbi, priest or imam could help with rules of conduct derived from holy scripts to save the soul. Charity was a prominent virtue. By helping each other and not charging interest for a loan one could save one’s soul. The identity of being a community member gave normative power to the rules. (Korsgaard 1996). You demonstrated your will to membership by following the rules. But towns and cities thrived through trade, which introduced ever new practices and wealth from the outside. The learned men had to respond to a diversity of questions relating to particular circumstances. They, in turn, had to refer questions to centres of learning for guidance. The answers would generate a drift in the meaning of central tenets, but also a demand for occasional compilation and clarification of diversified rules. Religion faced mounting problems of “control at a distance”. The parish structure was a strategic necessity, but centrally given bullas, fatwahs etc. would be distorted on their way towards real life application. Learned men would use parables, stories and similes in their pronouncements. The effect of this is a distinct increase of the knowledge of the actual business practices. By the time of the School of Salamanca (16th century and onwards) the stories were pretty accurate descriptions of actual practices. This, of course, tended to undermine the normative power of the (abstract) rules and also to provide ample opportunities to find loopholes, which also stimulated creative new designs of transactions.

Community as centre of authority

61

The forces of regulation became stronger and better organized with nationalist rulers and the treasures of the colonies to finance further wars. But trade, the traditional area of operations for banks, became increasingly directed by the national will to control resources (by those chartered companies), and regulations (by more efficient bureaucracy). The church, the traditional core of authority, was pushed aside (or joined forces with) the monarchy by Divine Right, and was replaced by a central administrative apparatus manned by graduates of the, by now, established universities with their faculties of law. Already in the 17th century non-aristocratic young men could be seen having impressive careers. The bourgeoisie was taking steps forward.

Note 1 Possibly under the influence of the saying from Ecclesiasticus (quoted from Ehrenberg 1928): “Noli foenerari fortiori te, quod si foeneravis, quasi perditum habe” (Lend not to him who is mightier than thou; or if thou lendest, look upon thy loan as lost).

References Alvarez Nogal, Carlos (2017) Los Bancos Publicos y El Decreto de 1575. Cuadernos de Historia Moderna. Vol. 42, no 2, pp. 527–551 Aristotle (350 bc) Nichomachean Ethics. Lyceum Azpilueta, Mertin de (1556) Comentario resoluorio de cambios. Salamanca Baeck, Louis (1988) Spanish Economic Thought: The School of Salamanca and the Arbitristas. History of Political Economy. Vol. 20, no 3, pp. 381–408 Boltanski, Luc (2009) On Critique – A Sociology of Emancipation. Cambridge: Polity Press, 2011 Braudel, Fernand (1977) Afterthoughts on Material Civilization and Capitalism (Transl. Patricia Ranum). Baltimore, MD: John Hopkins University Press Brown, Peter (2015) The Ransom of the Soul – Afterlife and Wealth in Early Western Christianity. Cambridge, MA: Harvard University Press Böhm-Bawerk, Eugen von (1890) Capital and Interest: A Critical History of Economic Theory. London: Macmillan Carande, Ramon (1987) Carlos V y sus Banqueros, 3 vols. Barcelona: Editorial Critica Carmona, Salvador, Rafael Donoso & Stephen P. Walker (2010) Accounting and International Relations: Britain, Spain and the Asiento Treaty. Accounting, Organizations and Society. Vol 35, pp. 252–273 Carmona, Salvador, Rafael Donoso & Philip M.J. Reckers (2013) Timing in Accountability and Trust Relationships. Journal of Business Ethics. Vol. 112, no 3, pp. 481–495 Cyert, Richard M. & James G. March (1963) A Behavioral Theory of the Firm. New Jersey: Prentice-Hall Ehrenberg, Richard (1928) Capital & Finance in the Age of the Renaissance: A Study of the Fuggers and Their Connections. London: Jonathan Cape Grice-Hutchinson, Marjorie (2015) Early Economic Thought in Spain 1177–1740. Indianapolis: Liberty Fund Hamilton, Earl Jr (1934) American Treasure and the Price Revolution in Spain. Cambridge MA: Harvard University Press Hutcheson, Francis (1755) System of Moral Philosophy in Three Books. London: Millar

62

Community as centre of authority

Jönsson, Sten & Lundin, Rolf A. (1977) Myths and Wishful Thinking as Management Tools. In Prescriptive Models of Organizations. C. Nystrom & W. Starbuck, eds. TIMS Studies in Management Sciences. Volume 5. Amsterdam: North Holland Publishing, pp. 157–170 Korsgaard, Christine (1996) The Sources of Normativity. Cambridge: Cambridge University Press Langholm, Odd (1979) “Price and Value in the Aristotelian Tradition – A Study in Scholastic Sources. Oxford: Oxford University Press Langholm, Odd (1984) The Aristotelian Analysis of Usury. Oslo: Universitetsforlaget Langholm, Odd (1992) Economics in the Medieval Schools – Wealth, Exchange, Value, Money and Usury According to the Paris Theological Tradition. Leiden: Brill Langholm, Odd (1998) The Legacy of Scholasticism in Economic Thought – Antecedents of Choice and Power. Cambridge: Cambridge University Press Maali, Bassam & Napier, Christopher (2004) Religion, Regulation and Accounting: The Creation of Jordan Islamic Bank. Working Paper. University of Southampton Machiavelli, Bernardo (1513) The Prince. Florence McCloskey, Deirdre N. (2010) Bourgeois Dignity; Why Economics Can’t Explain the Modern World. Chicago: University of Chicago Press Mercado, Tomas de (1571) Summa de Tratos y Contratos. Book IV, Chapter IV. Salamanca: Edicion Nicolas Sanches de Albornoz Munro, John (2001) The Origins of the Modern Financial Revolution: Responses to Impediments from Church and State in Western Europe, 1200–1600. University of Toronto. Working Paper no 2 for 2001 (UT-ECIPA-MUNRO-01–02) Noonan, John T. (1957) The Scholastic Analysis of Usury. Cambridge, MA: Harvard University Press Parks, Tim (2005) Medici Money – Banking, Metaphysics and Art in Fifteenth Century Florence. London: Profile Books Rivas, Léon Gómez (1999) Business Ethics and the History of Economics in Spain “The School of Salamanca”: A Bibliography. Journal of Business Ethics. Vol 22, pp. 191–202. Roover, Raymond de (1963) The Rise and Decline of the Medici Bank. Cambridge, MA: Harvard University Press Ruiz Martin, Felipe (1969) Los planes frustrados para crear red de erarios y montes de piedad (1576–1626). Cuadernos Hispano-americanos. Nos 138–140, pp. 613 ff Scanlon, Thomas (2014) Being Realistic about Reasons. Oxford: Oxford University Press Schumpeter, Joseph (1954) The History of Economic Analysis. London: Allen & Unwin Searle, John (1983) Intentionality: An Essay in the Philosophy of Mind. Cambridge: Cambridge University Press Smith, Adam (1776) An Inquiry into the Nature and Causes of the Wealth of Nations. London: Strahan & Cadell Soto, Jesus Huerta de (1996), New Light on the Prehistory of the Theory of Banking and the School of Salamanca. The Review of Austrian Economics. Vol. 9, no 2, pp. 59–81 Steensgaard, Niels (1969/1970) Det syttende århundredes krise. Historisk Tidskrift, Band 12 Temin, Peter & Hans-Joachim Voth (2004) Riding the South Sea Bubble. American Economic Review. Vol. 94, no 5, pp. 1645–1668 Ulloa, Bernardo de (1740) Restablecimiento de las fábricas y comercio espanol (2 vols). Madrid Utzáriz, Geronomo (1724) Theoria y práctica de commercial y marina. Madrid (English trans. by John Kippax, Theory and Practice of Commerce and Maritime Affairs. London. 1751)

3

Transition from regulation by State to regulation by Market

In this chapter I present the idea of mercantilism, which required a more developed State administration, while princes continued to make war in the name of the nation, and look at how the exploitation of newly established colonies provided an inflow of raw material to feed the on-going industrial revolution. The modernist ideas of science and the equality of men set the stage for a broad advance of the bourgeoisie and entrepreneurship. This was a golden age of merchant banks. The case of Barings Bank is used as illustration; faced with undetected, IT-based internal fraud in the “mania” stage of the financial crisis, the bank finally failed in 1995. A conception of the “the market” emerged.

3:1 Transition The discussion by the Doctors of Salamanca heralded the arrival of mercantilism as well as the Enlightenment, which allocates a much larger role for the State (“Hierarchical Control” according to Streeck & Schmitter (1985)). There had been a transition to views of exchange as a matter for markets, rather than deals between individuals. This view of markets gradually assumed the form of systems (common estimates) and of the State becoming the lead authority in regulating social order rather than the Church with its community organization (“Spontaneous Solidarity”). Here we take a giant leap from the middle of the 17th century to the late 19th. This encompasses what has been called the era of “classic economics”, which included economists becoming policy actors (compare “political economy”), much like the arbitristas in Spain a century earlier. This was made possible by mercantilism and the Enlightenment paving the way for the establishment of economics as a science. Schumpeter (1954) in his History of Economic Analysis avoids dividing history into “periods” – for him all change is gradual. He discusses “Critical Situations” as change-over points, characterized by first a fresh activity struggling with the “deadwood” of traditional habits and then a settling down with a remarkable academic achievement (like the work of J.S. Mill) that marks the beginning of a new development. Interestingly he places Adam Smith (1776) at the end of the old period (the first five chapters of the book being a repetition of Aristotle’s

64

Transition from State to Market regulation STATE “Hierarchical Control”

“Theory/Debate”/ Principles

“Theory/Debate” Modernism Mercantilism Baring

Practices Principles

MARKET “Dispersed competition”

COMMUNITY “Spontaneous Solidarity”

Figure 3.1 Transition from regulation by “State” to regulation by “Market”

reasoning about exchange and prices), while the new period, called by some “classical economics”, starts with Mill. Also, there is another interesting aspect of Adam Smith’s oeuvre that places him at the end of a period rather than at the beginning of a new era; his introduction of the “impartial observer” as a method for moral judgement in his Theory of Moral Sentiments (1759). In that book, he advises the reader to ask: “What would an impartial observer think about what I am about to do?” One could ask whether this “impartial observer” is some universal representative of moral competence or if s/he represents the “common estimate” of the community where the actor is a member. Whatever the interpretation it places Adam Smith with one leg in each camp; on his way to leave “Community” as the basis for social order, via a regulatory State, toward a world view of society and markets as “systems” that can be studied in the same way as the successful natural sciences approach their objects of study, by measurement (facts, statistics) and analysis. The centre of authority now (for a while) becomes the State (hierarchical control), which uses experts and “tooled knowledge” (Schumpeter 1954) for its rational deliberation on policy. From Schumpeter’s point of view – he worked with the history of economic analysis – the time covered by the “transition” part, albeit extended to the end of the Second World War, lives up to his criteria for a “period”: there is a) struggle with deadwood from earlier periods, b) things settle down, c) there is some classical achievement (in our case John

Transition from State to Market regulation

65

Stuart Mill’s establishment of a basis for the liberal market economy, d) then there is stagnation again (those who “know” are in agreement).1 Two developments inter-mingle here – the development of ideas up to and through the Enlightenment (during the 60 years up to the French Revolution), and mercantilism. We will rely on Schumpeter (1954) for the former and Magnusson (1999) for the latter to set the stage for Barings Bank that rode the wave of progress through the Golden Age of merchant banking up to the postwar era of de-regulation that marked its demise.

3:2 The history of economic analysis according to Schumpeter through to the Enlightenment Schumpeter’s impressive book the History of Economic Analysis (1954), with more than 1,200 pages, is focused on events and authors who contributed to the development of the analytical side of economics; it takes us to the 19th century, but like all developments there is a pre-history. Schumpeter has much praise for the intellectual work done by the scholastics and how they set the stage for the development of “tooled knowledge” in economics, which benefitted from a general development of social sciences (especially the introduction of psychology as the basis for the analysis of individual decision making), and statistics. Schumpeter starts off with a declaration of content, and with his thesis that methods are historically conditioned (as is ideology). He justifies this as being an attempt to give the reader an opportunity to assess these claims by him- or herself. For example, in a note he defines a principle as “any statement that we (or the author under discussion) do not propose to challenge” (note 1, p. 15).2 This indicates the rather obvious precondition for all analysis – that there has to be a set of assumptions and definitions that are “given” in the analysis. If we question everything there will be no use for analysis. There was a massive heritage from the scholastics (some would call it “deadwood”) when the transition to modernity started in the 17th century from its basis in sacred texts interpreted by wise men. When reading Schumpeter in relation to my set of case studies one should remember the large number of choices to make in providing a comprehensive account of the history of economic analysis. Furthermore, one should remember that some reviewers of Schumpeter’s book – the Anglo-American ones – complained that he did not do justice to English-speaking scholars (one should also consider whether the current dominance of American scholars in the literature might have something to do with language preferences). But, above all, one should note, from the start, that almost all reviewers, although describing the book as “brilliant”, also pointed out that there are many contradictions in the text. One of them concerns the nature of economics (even if he argues that its methods are historically conditioned): For example Schumpeter claims that economists peddle political recipes (p. 19), that there is a meaningless distinction between economics and “what is now called business economics”, and

66

Transition from State to Market regulation

that neighbouring, applied fields have preserved altogether too much independence from general economics (“which is slowly being surrendered in the case of accounting”). He says (p. 26) that “to a considerable extent, economists have been jurists” and (p 27) “economists never allowed their analysis to be influenced by professional psychologists, but always framed themselves such assumptions … as they thought desirable”. But he also points out that “there is a wide gate for ideology to enter into this (scientific) process” since economists capture the phenomena they find interesting in the flow of problems of their time and form the concepts and scientific models to investigate them. This bodes well for us, interested as we are in how banks navigated among the shallows of private and public daily business of their time. When it comes to dividing history into periods (and we have already named this chapter “transition”) Schumpeter is (as mentioned) looking for (hesitantly) limiting events like, a) struggle with “deadwood”, b) things to settle down, c) there is some “classical achievement” and then, d) stagnation as only application remains. We need to remember that his “achievements” are academic ones. Here we are interested in the period that ends about 1790 with the success of Smith’s Wealth of Nations and the merger between academic knowledge with related concepts and the knowledge of “men of practical affairs”. (Science + practice = engineering, as it were). The 19th century saw the exploitation of colonies in competing empires, and the industrial revolution. Banks were involved. Huge resources flow, via the State-controlled trading companies, like the South Sea Company, into private hands with a need to invest. Railroads needed financing etc. Schumpeter reminds us that the foundation for the (little) progress that was made in economics in the period up to 1790 was scholasticism. Most writers on economics up to the 18th century were clergymen or lawyers. It was the Roman contribution to provide those writers with a “juristic logic” that was taught in universities from the 12th century. But scholasticism was accompanied by a growth in capitalism as the bourgeoisie in the cities grew rich by being “in business”. Also, the new empiricists who conducted evermore daring experiments and developed tools of measurement and observation came from the Church. (Copernicus, for example, was a canon even if he never took the wows to become a monk, and he had permission from the Pope to publish.) Schumpeter (1954, p. 115) points out that the fundamental factor that raises interest rates above zero is the prevalence of profit. Classical scholastics did not see that, but Molina coined the phrase “money is the merchants’ tool”. A prolonged period of groping for the relation between interest and profit ensued. Molina also (clearly) discussed Natural Law on the one hand, the dictates of Reason on the other, and related them to what was socially expedient (= common good). There were two “counter”-forces (p. 110): a b

the tendency to associate Natural Law with primitive conditions (see Rousseau’s glorification of Nature) the clear relation between Natural Law and the Rights of Man.

Transition from State to Market regulation

67

This leads to a rejection of any economic theory built on Natural Law. But with Molina’s definition of Natural Law (reason applied to particular facts) it is only natural to conclude that “data of the social situation determine… uniquely a certain sequence of events (or states) or would do so if they were allowed to work themselves out without further disturbance” (p. 112). This was 1659, even if it sounds like present day neo-liberalism. On this platform, the philosophers of Natural Law (as distinct from Devine Law) could work, notably Hugo Grotius (Dutch lawyer), Thomas Hobbes (Oxford, political sociologist) and, John Locke (Oxford, civil servant). Schumpeter also mentions Pufendorf (Heidelberg and Lund, jurist) as a follower of Grotius. These “social scientists” lived in the “heroic age of mathematics and physics”. The search for “laws” of social systems was initiated by a focus on “Philosophical Empiricism” (p. 120) with a few tenets: a b c d

knowledge of the individual is derived by experience experience has the form of sense impressions prior to experience the mind is a blank impressions are the ultimate elements into which all mental phenomena may be resolved (reasoning). This means a resolution of the “soul” into atomic impressions.

This development of a psychology amounting to a theory of Human Nature took place against the background of a large number of texts concerning policies of improvement of society written by pamphleteers in different countries (Schumpeter also uses the label “consultant administrators”). These texts, it should be remembered, were written about policies for nations that were poor and agricultural, and where manufacturing was seen as a promising road ahead. Most suggestions promoted large projects (like building canals) and “monopolistic” solutions (like importing raw material via large companies, e.g. the East-India Company of many countries) and exporting manufactured goods. The emerging theory of Human Nature described individuals that were supposed to be citizens in this brave new world. But there was a gap; how to make good citizens out of the egotists this Human Nature brought. All these “sense impressions” were problematic since they do not lend themselves to measurement and calculation (this was the time of Enlightenment – the idea of rationality must survive!). A series of British scholars provided building blocks (Hobbes: egotism; Shaftesbury: altruism; Hutcheson (Adam Smith’s teacher): further altruism; Tucker: satisfying desires), used by Hume and Bentham to sum up into an enlightened self-interest, guided in the words of Adam Smith (1759) by the “impartial observer” procedure – one should always ask oneself “What would an impartial observer think about what I intend to do?” Against this background it is easy to see “utility” as the setting for Smith’s Wealth of Nations. As mentioned, the idea of sense impressions was problematic; it had to be made scientific. This was achieved by classifying the ways desires can be

68

Transition from State to Market regulation

satisfied into “pleasure” and “pain”. One unit of “pleasure” extinguishes one unit of “pain”. The degree of happiness could then be calculated in terms of utility (“pleasure” minus “pain”). The “common good” becomes the aggregated utility calculated by rational men. With each individual striving for happiness, the common good – the greatest happiness to the greatest number – will result (Smith 1776; Bentham 1789). It should be noted that Schumpeter (1954, p. 134) is quite without mercy when he condemns utilitarianism as completely useless when it comes to interpreting history and historical changes. In economic theory in the narrowest sense it is unnecessary but harmless. Why, then, did it become so popular? Perhaps because most of the authors were arguing for remedies for deplorable states of affairs that were caused by irrationality. They needed “utility” to justify reforms or betterment projects. This is what characterized the writers on economic matters post- French Revolution. Adam Smith was such a pamphleteer when he wrote Wealth of Nations in 1776, arguing for free trade, laissez-faire and colonial policy, although against mercantilism. Removal of all constraints, except those that are imposed by justice, in combination with free interaction of individuals, will not produce chaos, but an orderly pattern! Schumpeter agrees that Smith’s argument is a brilliant one, but “the fact is that the Wealth of Nations does not contain a single analytic idea, principle or method that was entirely new in 1776” (1954, p. 184). These opinions were in fashion at the time. Smith “became the teacher of professors until Mill’s “Principles” in 1848”. Schumpeter (1954, p. 380) reminds us of the fact that “We still underrate the pre-Smithsonian achievement; we still overrate the achievement of the ‘classics’”, before he embarks on the development of economic analysis/thought of the 19th century. This is a period of “professionalization” of economics, not that economics was yet a full-time endeavour by professors of economics, but there was progress, and England came out first by virtue of a small number of masters. One of these “full-time workers” was Karl Marx, whom Schumpeter provides with a separate section because he should be looked upon “as a whole” as it were. He has a sociological and an economic framework. The only economist Marx treated as a master was David Ricardo whose conceptual layout he adopted. As to his sociological framework he relied on Smith (labour value), Boisguillebert, Rousseau, and Lingnet. Schumpeter (1954, p. 381) gives Marx credit for two achievements: 1) that he was the first to depict the capitalist process (inspired by Ricardo and François Quesnay), and 2) that his theory was evolutionary by virtue of his efforts to uncover a “mechanism that by its mere working and without the aid of external factors turns a given state of society into another”. Because Marx was such a difficult writer, and due to his leaving so many unfinished manuscripts that had to be edited (by, e.g., Engels), Schumpeter refers the interested reader to Sweezy (1946) for a comprehensive and friendly overview. A final warning is issued (Schumpeter 1954, p. 392); when Marx senses a weakness in his own argument “he rises, in defence, to the

Transition from State to Market regulation

69

heights of his vituperative rhetoric, which therefore serves to indicate the spots at which there is something wrong”. In trying to comprehend this dynamic period of liberal development (e.g., War of Independence in the USA, French Revolution) and free trade development, we must distinguish between “political liberalism” (sponsorship of parliamentary government, freedom to vote, freedom of the press, rule of law etc.) and “economic liberalism” (removing the fetters to the private enterprise economy, reducing the functions of the State to a minimum), which according to Schumpeter, do not necessarily go together, even if the period is one of ascendancy of the bourgeoisie. Again, the progress is achieved in a continuing interaction between practical problems and theoretical development. Economic liberalism did not only mean free international trade, but also domestic regulations had to be changed to make free trade efficient. Gladstone was an important actor in his “taxation for revenue only” policy (no progressive tax) and the reduction of the functions of the State, which implied rationalization of the remaining functions. (One can sense the Market gaining prominence.) Theoretically the “Zeitgeist” fitted “Utilitarianism”, hand in glove, represented by a group of academics (Jeremy Bentham, James Mill, and J.S. Mill) centred at Cambridge. Schumpeter gives an exposé of the different aspects of the intellectual topics (Utilitarianism, Romanticism, Historiography, Environmentalism in Sociology and Political Science, Evolutionism (Darwin), Psychology) to guide us to the main figure; J.S. Mill, and his System of Logic (1843) and Principles of Political Economy (1848), merging scientific method and political economics, which Schumpeter admires (both books were bestsellers – although, perhaps, not as popular as Darwin’s Origin of Species – not least because they were so well written). Mill’s Logic contains, in Book III, an introduction to the core of the scientific process, His argument for generalization from experience, the axiom of the uniformity of the course of Nature, and the theory of valid induction derived from it. His translation of science to the social sciences will, of course, meet some objections today, but “he watered down physical causation so radically as to make its extension to social sciences practically harmless” (Schumpeter 1954, p. 452). In Political Economy he developed the standard method of economics in his Concrete Deductive Method, supplemented by “Inverse Deduction” and “Historical Method” (for research into historical changes of the social setup (p. 452)). Mill argues for the impossibility of universally applicable practical maxims and urges us “to study actual human behaviour in all its local and temporal varieties” (p. 452). Schumpeter is sympathetic and claims that if we had done that it would “have taken off the curse from the economic man for all times” (p. 452) and finishes his comment on Mill with a strong recommendation to read Book VI again – carefully. With this the base for the liberal economic view, and the scientific backing of it have been covered, and we leave it there with a plan to resume the narrative at the time when the struggle between liberalism and socialism came to

70

Transition from State to Market regulation

an apex in Vienna around the First World War. This also includes how Austrian economics came to be the cornerstone of neo-liberal thinking later on. For now we return to the practical debate on how the State should manage the in- and outflows of capital for the common good of the Nation.

3:3 Mercantilism – the origins of political economy and, consequently, of economic policy Magnusson (1999) is focused on how mercantilism and its ideas were coloured by historical events and how explanations to the then current economic plights gradually paved the way for understanding the economy as a system that could be subjected to interventions by governments to enhance performance. Magnusson (1999) points out that what we call “mercantilism” really is a series of somewhat related policy debates contained in a very large number of pamphlets and brochures – written by those “government consultants” – that started with the severe economic crisis of England in 1620. (Spain was already in trouble, and the 30 Years’ War was about to gain momentum.) The problem then was that “the old drapery” (broadcloth, made from wool) produced and exported by England was overtaken and virtually wiped out by a lighter cloth “the new drapery” (calico, made from cotton) provided by Holland. It was a devastating blow to the economy. Unemployment in this dominating industry grew very rapidly. Investigative commissions were established and a vast literature on the causes and remedies emerged. First it was a lack of money that was seen as the cause, after all the East India Company exported a lot of money and precious metals for investment in its business. Later a balance of trade discourse emerged. There was also a debate on the employment effects of trade. Magnusson (1999) argues that these debates produced a common language (“langue”), even if the different authors presented different arguments (“parole”), rather than a conceptually homogeneous worldview. The label “mercantilism” marks the “langue” of economic policy in Europe during the period from the dissolution of the medieval guild and trade organization to the time of the laissez-faire doctrine. Later writers, like Adam Smith (1776), are keen to portray the “mercantilists” as irrational believers in regulation and sovereign power, but it seems more rational to look upon them as pragmatists trying to devise solutions to the problems of the day. Most of the arguments used by Adam Smith had already been presented by other authors. It was the combination of arguments that rendered Smith’s text on trade forceful – Magnusson even points out that it is doubtful whether Smith was a free-trader at all. He supported the Navigation Act (the 1651 Parliamentary Act that ruled that all imported goods (including fish) had to be brought by English ships). It was the Dutch that were in the focus of the debate, they were catching all the fish in the North Sea, and they had built a trading empire. Holland was described with some envy by one of the writers (Mun 1654) as the warehouse of “many places of Christianity”. How could the Dutch build such riches

Transition from State to Market regulation

71

without manufacturing anything? One should remember that from 1652 (the year after the Navigation Act, and a few years after the peace treaty of Westphalia) until 1713 England was more or less constantly at war (three times with Holland, twice with France, twice with Spain), which may explain the intensity and diversity of arguments. Still mercantilism is an important stepping stone for the development of classical economics and banking. Some of the arguments were recycled in the debates in the 1930s around Keynes’ proposals. Heckscher (1931), in his magnum opus, described mercantilism as just another phase in the development of economic policy. It had little to do with the economic realities of the time. As before it was a matter of strengthening the power of the State to interfere with economic development. What was new was the means used to further this goal. Heckscher made the will to control visible (in opposition to the self-regulation argued by liberals). Viner (1954) tried to understand mercantilism from the perspective of modern theories in the trade area. He comes out in support of Adam Smith’s presentation of mercantilism as regulation being, the result of lobbying from special interests. Schumpeter (1954) argues along the same lines. Mercantilism can only be understood as rational if seen as promotion of special interests. Keynes (1936) pointed out that early economists – those active in the time of mercantilism – have been mistreated by the classical school. What we should learn from mercantilism is that the upsurge under laissez-faire will be broken by inadequate new investment (that is why the State has to interfere to uphold employment). Mercantilism addressed this issue. Magnusson (1999) brings out some of the strands in this colourful tapestry. An early actor was Gerard de Malynes, a “monetarist”, who argued that the cause of the troubles was the unfair exchange rate, caused by a conspiracy of foreign bankers and currency traders. By forcing the rate down, they made it necessary for British merchants to sell their wares prematurely at low prices in foreign markets since they had to pay their bills of trade. The solution was strong regulation (by the State) to uphold a par pro pari exchange rate (exchange only in accordance with our money’s real, inherent value). Thomas Mun was another contributor, and director of the East India Company from 1615. His company had been accused of exporting money from the country and that this was the cause of the depression. Besides defending the East India Company (it generated many jobs in Britain) Mun (1664) argued that a nation must export more than it imports. This, in turn, will generate money flows, which, if used for further trade, will increase the capital assets of society. The State needs to promote the export of manufactured goods and the import of raw material. He is especially aggressive toward the Dutch dominance of the fish trade. This articulated the “balance of trade” aspect of mercantilism. Similar debates appeared in other countries with slight variations. Germany (comprised of many small states at the time) established an inward-looking view (“Reichskameralismus”), which focused on order, administration and proper bookkeeping. France, finally at peace after a long period of domestic warfare, was in

72

Transition from State to Market regulation

a re-building phase with a stronger “dirigist” State, with Colbert as a leading figure, first oriented toward self-sufficiency, and later toward expansion of trade. Spain with its large inflow of precious metals from Latin America had already under the period of the Salamanca School (scholastics) pondered the effects of this inflow of money on economic development (de Azpilcueta 1556). Focus came to be on the design of the tax system and how to promote the establishment of manufacturing, which, obviously, required investment in fixed assets with longer planning horizons. In sum, the mercantilist discourse delivered:     

the belief that the monetary flow between countries was determined by real economic forces, i.e., the balance of payment the belief that the market mechanism was the dominating factor in this process the belief that the Christian moral order (scholasticism), or ethics, had little to do with this the view that the economy is a system of forces and the view that the economic world should be subject to systematic study (Magnusson 1999, pp. 115f.)

One might add that it also comes through that the participants in the debate were in favour of certain economic policies to promote the welfare of their nation. The State had now been established as a legitimate player and the beliefs listed above provided a basis for economic policy formation. Merchant banks gained importance in the mercantilist era, but they were under scrutiny, and they now had a complex of relations and investment opportunities to attend to beside trade. They needed strategies for trade, as did the State. The problem was that banks were family owned and rather small, in terms of personnel, to have a capacity to implement strategies successfully. The smallness also made them vulnerable to withdrawals of capital in connection with death duties, etc. Still it was merchant houses that had the head start in the modern era. They relied on trust and their good name in the right quarters to flourish. However, development was different in different countries, partly because of natural endowments, but also because different policies came to be applied. Merchant banks, engaged in trade between several countries had to learn to deal with more than one regulatory regime.

3:4 Industrial development – the outcome of economic policy application? We need to go into more detail on the concrete economic development in different European countries to see, first, how differences emerged, and, second, how bank activities moved to London with its bee-hive of merchant banks. The variety in industrial background also provided the context for ideologies to take root. Their varying appeal, no doubt, had to do with the

Transition from State to Market regulation

73

distribution of wealth and the accumulation of groups of proletariat inhabitants in fast-growing industrial towns and cities. It is probably a good idea to remind ourselves of the problem with description of the cause of the “hockey-stick effect” (the extraordinary economic growth) that is at the centre of the deliberations of McCloskey (2006, 2010, 2016). After having dismissed several proposed explanations to the rapid economic growth during the 19th century McCloskey (2010, Chapter 39) claims it was “bourgeois Dignity and Liberty entwined with the Enlightenment” that provides the plausible candidate – it was words expressing ideas! “What is new on that scene?” one must ask. It was the new liberty symbolized by the French Revolution, a truly bourgeois revolution (granted it did not hold to its promises – like most revolutions), and the bourgeois dignity gained by the basic virtues (Courage, Justice, Temperance, Prudence – those were the pagan ones – and Faith, Hope, Love – those were the Christian ones) from antiquity and scholasticism now being revived by enlightenment and entrepreneurship. Trade across the seas and industrial revolutions tilled new ground for human ingenuity. The man with a “good name” could achieve almost anything – and there were plenty of examples to prove it! Merchant banks were in a good position to participate, provided that they were in the spot where the action was. The problem then was that business practices developed in step with the local material conditions, and then there were several centres to which the money flowed. 3:4:1 The “material conditions” in some important countries These short accounts of the industrial and political development in a selection of countries is based, chiefly, on Cameron (1972). Austria 1800–1914 After the Napoleonic wars and the Revolution of 1848 there was a period of several decades for Austria of industrial growth, called the “Gründerzeit”. This was followed by a crash in 1873 with a long recovery period. From 1880 industrial output increased but growth was slow up to 1896 that saw an upswing that ended in the European depression of 1900. From 1903 to the beginning of the First World War there was renewed growth. A Gerschenkronian “spurt” can be found for Austria from 1896 onwards (sometimes called “the second Gründerzeit”). Before the 1848 revolution the banking industry was dominated by the National Bank that served as central bank with monopoly of note issue. This bank served only the very wealthy bank houses, which were involved mostly in government loans and loans to the nobility. There was little traffic with industry. Still there was gradual development of industry, with beginnings on the large estates where landowners would set up ventures (textiles, mining, metallurgy), albeit on a small scale. Prudency made the existing banks favour already established firms. Around the crash in 1873 several banks were turned

74

Transition from State to Market regulation

into joint-stock companies and speculation flourished. The effect of the crisis seems to have been that banks withdrew from involvement in industrial development and focused on (short term) current business. One explanation for this withdrawal (beside the crisis experience itself) was changes in tax legislation that discriminated against the joint stock form of incorporation. One interesting aspect is that from the 1860s onward banks used a business model that included that they would take over all of the output of given firms on a commission basis to sell through special sales offices (coal, sugar, petroleum, lumber…). Industrial development was hampered by excessive caution. There was government intervention to promote industry in order to keep up with Germany. Banking in Prague gradually grew to become a competitor to Vienna as a financial centre. Italy 1861–1914 Up through the 1800s agriculture in Italy was low yielding in comparison with other European countries, and there was still a small market for manufactured goods. However, there was “a big spurt” in the sense of Gerschenkron from the last years of the century up to the First World War. Industrial growth requires, obviously, a domestic demand for such goods, plus a capacity to aggregate and distribute capital to promising projects. The banking system was originally not designed for this kind of industrial finance, but after unification (1871) there were governmental initiatives to promote growth (new tariffs, promotion of Italian shipping, and, in 1886, the first modern steel mill (together with banks and industrialists)). The system of savings banks was too restricted by their charters to provide much more credit than to municipalities. In 1876 the government set up the postal savings bank, however, the capital from savings accounts there could only be invested in government bonds. But since the State came to play an increasing role in industrialization this was in fact an important channel for funding industrial investment. Cooperative banks, oriented toward small local businesses (members), grew in numbers. By 1914 this category provided about 1/3 of the industrial and commercial credits by banks. Large commercial banks (banche di credito ordinario) funded the large firms. They also assisted in turning firms into joint stock companies and with securities issues. There were recessions regularly, where the new limited companies often failed. Banks compensated for the industrial risks by speculation in real estate. The government counteracted by setting up the central bank, Bank of Italy, as a lender of last resort, in 1894. This helped reduce the endemic financial panics of Italy. Spain 1829–1874 The situation in Spain during the 19th century was not very up-lifting. After a promising development in the 18th century the outright failure of industrialization

Transition from State to Market regulation

75

must be judged to be a failure of domestic policy. In spite of the fact that the country was unified and independent it did worse than other European countries and lagged further behind. One of the policy mistakes was to carry out a land-reform in the way that the government took land from the Church, the nobility, and municipalities, and auctioned it out in small pieces. The compensation to the former owners was low, which reduced wealth considerably (with lacking industrial investments as a consequence), at the same time as the agricultural structure suffered. Another mistake was that the State budget was running at a deficit (funded by loans from banks) in spite of the revenue from land sales. On the average the State borrowed four times as much from Bank of Spain as the private sector from 1852–1873. The Caja de Depositos, a government agency that had the largest volume of deposits used all its funds to finance government spending. A third mistake was a law, passed in 1848, which required all corporations to apply for government approval through a lengthy administrative procedure. This discouraged entrepreneurship. The law was dismantled in the 1850s to promote railways, banking and mining (but not manufacturing). Investment in railways was selected as the solution by the government, but since the investment came too far in advance of demand, it did not achieve the desired effects on manufacturing investment. Railways remained low profit or loss businesses. The risk aversion of banks in the crucial years of the international financial crisis (around 1857) meant that they followed government recommendations focusing on lending to railways and the government. Serbia 1878–1912 During the period from being granted independence by the Berlin Congress in 1878 to the beginning of the Balkan wars in 1912, Serbia had an opportunity to set industrial development in motion on its own. Although that period was short the conclusion is that it failed. By 1911 Serbia was comparatively underdeveloped. One important structural change that did occur, however, was the establishment of a large financial framework. By the end of 1911 the country had 176 commercial banks, including four foreign affiliates. Industry prior to 1893 consisted of flour mills and other production facilities related to agriculture. Land-locked Serbia was dependent on Austria-Hungary for export and import. Livestock was an important export leader. The newly independent State of the early 1880s had budget problems; a large part of the expenditure went to the military but administration also grew. State industry was almost exclusively for military needs plus some infrastructure investments. The government claimed it promoted industry, but action was limited to exemption from some taxes and import duties. To improve the access to credit facilities a central bank (although private) was set up in 1884. Its first issue of goldbacked 100-dinar notes failed. A later issue of 10-dinar notes was more successful and the money supply grew. This encouraged the founding of a large number of banks in 1884–1893. (There were many small savings banks at the time.)

76

Transition from State to Market regulation

A decline in the export of pork contributed to the increased money supply since traders had little use for trading credits. This was the opportunity to initiate industrial growth, but priorities were set on other grounds. In an effort to reduce its dependence on the Austria-Hungary empire Serbia began (in 1904) to import military material from France and established a customs union with Bulgaria (in 1905), which made imports from Austria less competitive. Austria responded with a closure of its frontiers to Serbian pork in 1906. Serbia refused to give in and invested (with French credits) in meatpacking and sought export routes via Bosnia and Herzegovina. Russia supported the Serbian ambitions. War was imminent when a German ultimatum forced Russia to stop its aid to Serbia, and Serbia to sign a new trade agreement with Austria. Still these activities had also stirred trouble in Bosnia and Herzegovina (the provinces recently annexed by Austria). It was here (partly) that the First World War was initiated. The Austrian empire saw its opportunities to expand to the southeast, but met difficulties in integrating ever more cultures into the empire. Japan 1868–1930 The period described here starts with the Meiji Restoration in 1868 when Japan opened up to modernization after having been a closed, traditional society with old traditions (e.g., samurais) for centuries. It ends when Japan entered into its imperialist war efforts towards China and later in the Second World War. One can divide the period into three sub-periods; a transition after the Meiji Restoration, “the spurt” 1885–1905, and an initial modern economic growth. THE JAPANESE TRANSITION

The Meiji government, striving toward modernization, had to increase revenues, establish a sound currency, and a modern banking system. Progress was slow. It took a crisis, the Matsukata deflation 1881–1885, to set the stage for modern growth. Banks had stuck to traditional lending activities directed toward agriculture and commerce rather than bond issue and industrial ventures. The few entrepreneurs had to finance projects, for instance in the textile sector, from savings, relatives and surplus from other activities. THE JAPANESE SPURT

In the last 15 years of the 19th century and the period up to the RussianJapanese war of 1905 the economy had its first wave of industrial investment. Three out of the five big banks (Mitsui, Mitsubishi, Yasuda) were active in financing industrial growth and came to position themselves as the core banks of the three largest industrial groups (“zaibatsu”). The strategies of these banks varied somewhat, although short term credits dominated. Long term credits chiefly went to smaller companies with close links to the bank. This constituted

Transition from State to Market regulation

77

the beginning of the “zaibatsus”. However, one can also note that a large proportion of the banks’ investment was in government bonds. During the period between the wars the banking system of Japan came to look even more like the German one with banks holding large shares of equity in groups of firms. This transition was reinforced as the “zaibatsus” had grown large enough to be self-financing in the war boom, and the banks themselves had become large enough to embark on their own growth strategies (growing deposits, share issues, mergers). There had been a series of bank runs in the 1920s and now the public preferred to keep their savings in big banks. Loans to non-zaibatsu firms increased. One of the bank runs mentioned above happened in 1927 due to an accumulation of “earth quake bills” in many banks. These bills were notes that borrowers were unable to pay after the earth quake of 1923, but which were guaranteed by the Bank of Japan. These “toxic assets” accumulated in banks but decisions by the government to provide bail-out loans to the banks came slow. The options in monetary policies for the Bank of Japan were reduced, and people worried about their deposits. Furthermore, some of the weakened banks had become captives of their clients, who forced them to provide unsound loans lest previous loans be lost. The re-payment of those secondary loans – and hence the survival of such banks – came to be dependent on the clients’ success in their new endeavours. The Ministry of Finance sought to stabilize the financial system by encouraging smaller banks to merge from 1924. The larger banks were quite active in acquiring smaller banks too. Hereby the Japanese banking sector came to be much better consolidated than its counterparts in Europe and the USA. Even if the early period had been characterized by banks investing (long term) in relatively smaller companies (with relatively high risks) the later development toward similarity with the German system is clearly visible. USA divided up to 1865 LOUISIANA 1804–1861

Louisiana, purchased from France in 1803, is interesting since it developed a banking system based in agriculture rather than industrialization. At this time New Orleans was already a trading city with 10,000 inhabitants and accounted for 70% of all manufacturing in the State. Up to 1836 the State legislature chartered 20 banks all located in New Orleans, but with branches in the sugar and cotton plantation areas. The State promoted banking by issuing State bonds on their behalf or by endorsing bank bonds. By 1838 Louisiana had the second largest State debt in the USA, 95% of it on behalf of banks. Favouring banks like that was not well received by all. There was a bank run in 1837 and the panic lasted until 1842. That year the Louisiana Bank Act instituted bank reforms focused on cash reserves, and in 1845 there was a stop to the chartering of new banks. This restrictive policy retarded the economic development of Louisiana. One

78

Transition from State to Market regulation

significant effect was the shrinking of inter-regional trade via New Orleans. The kind of specialization of banks (property banks that provided mortgages to planters, improvement banks that financed canals, rivers and transportation facilities, and the commercial banks focused of trade credits) served a conserving purpose. Up to the 1850s banks had allocated only small portions of their credits to manufacturing, but now an amendment to legislation, allowing banks to count State bonds as reserves for bank notes expanded the space for such investment. However, this space was instead used for long term commitments in railroads. Since their funding was based in short term deposits this made banks vulnerable to bank runs. This illustrates how changes in transportation (and other) technology upset the delicate balance between the short and long term in banking. The United States 1863–1913 Just before the Civil War the US Congress initiated a uniform currency backed by US government bonds. This was successful in the sense that panics where depositors wanted to turn their deposits into specie were halted, but panics because depositors worried about the status of their banks continued (panics in 1873, 1884, 1893, 1907). The, perhaps, unintended effect of the currency reform was (a) to raise barriers to entry (minimum capital requirements), and (b) to increase the mobility of funds (one currency). This came to favour the financing industry, which, in turn, was quite different across states. Further, since banks with national operations were required to invest a proportion of their funds in government bonds, they became more closely linked to the financial policies of the government. This set the stage for monetary policies. Before the Civil War country banks tended to deposit some of their funds in other banks in trading towns up the stream of goods. In this way New York came to become a centre of concentration of bank funds, which enhanced its role in industrial investment. The federal budget (Washington) was running a continuous surplus to pay off debt accumulated during the Civil War. Thereby, a transfer of public funds to private hands emerged, which contributed to a very favourable climate for the post-war industrialization in the USA. As everywhere else, railroad building was a major target for investment. Banks, sitting on the flow of funds, could assist in the flotation of railway bonds. The engine effect of the banking system in railroads was so strong that there was an overproduction of railways. Furthermore, the expanded capital market was large enough to absorb new security issues to be used in the consolidation of industries through merger (Bell, Standard Oil, DuPont, General Electric, etc.). The US economy, which had almost exclusively been a matter of small firms (Chandler 1962) was transformed to “big business”. Summary on economic developments in the late 19th century These short notes about a selection of countries constitute an account of the practice and policy developments in various contexts and are intended to

Transition from State to Market regulation

79

indicate that national differences in banking contexts, if anything, increased during the 19th century. The reader should note that some combinations of practices and policies would generate a greater potential to aggregate funds for industrial development in a concentrated way. This was largely a consequence of the development of markets for financial instruments, which was in turn supported by the governments’ use of bonds to fund large parts of their budgets. In some countries a tradition of financing industrial development by direct credit to companies was established. This was usually accompanied by bank ownership of industrial firms to generate “industrial groups” with a bank at the centre. The most prominent example is, of course, Japan, but Germany and France had similar developments. A side-effect of this was that financial actors moved to London where secondary markets for all kinds of instruments emerged. In addition, the empire provided a steady inflow of resources. A brief account of how London took over from Amsterdam and Southern Germany will prepare the background for the Barings Bank case. Despite some progress London was still, at the beginning of the 18th century, a second-rate financial centre after places like Amsterdam and Southern Germany. Trade expanded, supported by a growing colonial empire and protected by mercantilist policies (like The Navigation Act). However, these policies were the seed of decline for the empire starting with the War of Independence in North America and the revolutionary ideas from France. Never the less, Britain came out winner of the Napoleonic wars and as ruler of the seas. In this period the role of the Bank of England expanded largely in connection with the management of the national debt that had increased rapidly as a consequence of wars. Amsterdam, on the other hand, suffered numerous bankruptcies in the crisis of 1763 (end of the Seven Years’ War). Then problems worsened for Holland through the Anglo-Dutch War 1780–1783, and finally the French invasion in 1795. With that the financial, mercantile and naval power of Amsterdam was broken. London stepped in – Paris had other business to attend to. Barings Bank has been chosen as a representative of the merchant banks that prospered in London during this Golden Age.

3:5 Case 4: Barings Bank The case of the Barings Bank gives me an opportunity to present some of the relevant features (for banking) of the economic development of the British Empire, the dominating economic power of the times when Barings had its golden years. So, I will start with the economic development and introduce Barings against that background. This account is largely based on Banks (1999). 3:5:1 A short British banking history Banking in England started in the wake of William the Conqueror’s occupation. Jews established business in Cheapside (City). Since they were not allowed to engage in trade or manufacture and had no legal status, they took

80

Transition from State to Market regulation

up money changing, and provided Norman kings with funds for wars. Defaults on such loans were rather common so high interest charges were required. This led to conflict, ending in the expulsion of Jews in 1290. The void was soon filled by the Lombards (Italians, merchants and bankers, from Florence and other cities). These Lombards introduced their experience of Bills of Exchange. By the 16th century the Italian banking houses had declined and their financial activities were taken up by merchants, brokers, scriveners and goldsmiths: merchants traded and provided credit by Bills of Exchange; brokers lent money against valuables placed in safekeeping; scriveners were clerical intermediaries who set up contracts and provided advice, discounted payment orders, and traded in gold; goldsmiths established in jewellery and became important financiers taking deposits and re-lending deposits. Goldsmiths’ deposit notes developed into a kind of bank note. The goldsmiths’ business was greatly promoted by the raid on the Royal Mint (a safe deposit, people thought) by King Charles I in 1640 where he removed 200,000 pounds in bullion. From the middle of the 17th century joint stock companies appeared. They issued shares to merchants and gentry against promises of participation in capital gains and dividends. Such shares changed hands informally via brokers (who “transact business for merchants”), and jobbers (who quote “two-way prices for their own accounts of stocks”). The first recorded “stock jobbers” appear in 1688. One place where these middlemen met to conduct business was the Royal Exchange, but there were other locales, not least Jonathon’s coffee house. Another coffee house was Lloyds, which became a centre for exchange of shipping information and later (from 1771) developed into an insurance business with members/underwriters retaining unlimited personal responsibility for possible losses. Economic developments Industry was growing steadily at the beginning of the 19th century, even if Britain was involved in war. At the centre of this growth was cotton. Imports and exports dominated the economy after the end of the Napoleonic wars. Soon the railway era began. The first railway project in Britain started in 1825, and by 1835 there were 21 listed joint stock companies trying to raise funds for railway networks. Britain and Europe at large were plagued by large national war debts and there were financial crises – 1825 brought runs on country banks throughout the system, with payment stoppages at many banks – over 12 months 145 banks failed. In this situation the Bank of England was successful in calming the financial markets by discounting government bills and Bills of Exchange to provide liquidity. Legislation strengthened the Bank of England in its role as central bank. A further crisis in 1839, emanating from the USA, marked the turbulence of the time. From 1840 and onwards free trade made great progress as trade restrictions (like the Navigation Act and the Corn Laws) were dismantled. By 1880 Britain accounted for 50% of the world’s shipping tonnage and British credit supported

Transition from State to Market regulation

81

a large part of the growth in trade. The empire generated revenue, e.g., in the form of “home charges” and interest payments from India. Industry grew – by the middle of the century Britain produced 66% of the world’s coal, 50% of its iron, 70% of its steel and 50% of its textile. Investment in railways was a driver of the financial sector, as was sovereign debt. London was now the undisputed centre. There were crises of course, many of them stemming from speculative adventures in the USA (cotton, land speculation, railway securities bubbles, states’ overspending). In May 1866 (Black Friday) the leading discount house (discounting Bills of Exchange) in London, called Overend Gurney, collapsed. The Bank of England analysed the system effects – and let it fall – but provided credit to carry the rest of the financial sector over. A major technological development in the form of the telegraph – the Atlantic cable in operation from 1865 – changed the conditions for international commerce drastically. The American Civil War shifted business to the North. The merchant banks had to adapt. They had been used to relying on their personal knowledge of clients’ creditworthiness. With the growing volumes and distances this was no longer possible. Furthermore, larger capital to carry risk was required. There were mergers and acquisitions and joint stock banks kept growing. The period between 1875 and 1913 is generally considered the glory years of Britain. The entire world economy was built around Britain with the City as its centre. Bagehot (1873, p.2) wrote: Everyone is aware that England is the greatest moneyed country in the world; everyone admits that it has much more immediately disposable and ready cash than any other country. London dwarfed New York and other centres in terms of the volume of bank deposits. That very volume also generated a need for joint stock companies in banking. The “Big 5” banks had emerged as the clearing banks by the First World War. Merchant banks saw this development with suspicion. Foreign banks in London granting trade credits to companies in their “home country” expanded during the late 1800s. It was now that the term “merchant bank” became widely used. And the category got new members; while there were 39 such banks in the City, by 1890 the number had grown to 66 by 1897, even though they remained small – Barings had 71 employees by 1903. Politics was important. Many partners of merchant banks were members of Parliament. The Second World War caused devastation for Britain as far as the basis for merchant banking goes. Britain had lost half of its international trade, two thirds of its overseas markets, and a third of its merchant fleet during the war. The position of the USA had grown proportionally stronger. Coping with the large post-war debt burden was an important task for the government. Industry needed restructuring. The traditional industries (textile, coal, shipbuilding) were in decline, other industries were fragmented; for example there were 11 car manufacturers in Britain while there were three in the USA. The Labour

82

Transition from State to Market regulation

Government in power from the war until 1951, and again in the 1960s and 1970s, created a framework for solving these restructuring problems by State ownership (National Coal Board, British Steel, British Gas, etc.). The policy was successful in the sense that unemployment was low (1–2%), as was inflation. In 1957 Britain declined to join the new European Economic Community (EEC), and banded together with other nations that stayed outside of the EEC to form the European Free Trade Association (EFTA). However, the struggle to defend the sterling by raising the interest rate and adding an import surcharge (in 1964) had to be abandoned 18 months later as this violated the EFTA agreement. The trade deficit and currency turmoil remained a problem exacerbated by the 1973 oil crisis. Britain had for a long time been the world’s largest overseas investor, but the wars had forced investors to liquidate investments and the revenue from such activities was smaller. Industrial production grew, though, and the management of pension funds had been de-regulated. This generated a new strategic field for merchant banks. And there was the US Regulation Q and Interest Equalization Tax (IET). Regulation Q prohibited payment of interest on short term deposits, and set an upper limit for interest on long term deposits. IET taxed US domestic investors holding obligations of foreign issuers. This set the stage for the Euromarkets (establishing secondary markets for this kind of instrument). The Eurodollar deposit was an off-shore short term deposit paying a rate based on the LIBOR. It originated in the Soviet Government worrying about the risk that its holdings with American banks might be frozen or restricted (late 1940s). So, it re-deposited dollar funds with the Soviet–controlled Banque Commercial pour l’Europe du Nord in Paris. From this further dollar transactions could be undertaken outside the control of US authorities. The Eurodollar was born and London was the entrepot at hand. From here we focus on Baring, with occasional comments on the other merchant banks. 3:5:2 Barings Bank Beginnings The Barings Bank stems from Groningen, where Peter Baring established a wool importing house in the 15th century. One of his descendants emigrated to Exeter – a trans-shipment point for linen from Germany to the West Indies and Mediterranean countries – from Bremen to start his own business in 1717. By the end of the Seven Years’ War (1763) two sons had established business in London as agents for the Exeter branch. Gradually, and after several reconstitutions of partnerships between members of the family, banking took on a more prominent place in the business. Barings’ strength was its ability to develop and maintain relationships with banking and merchant houses at key locations around the world.

Transition from State to Market regulation

83

One such link was with Hope & Co. in Holland. By the turn of the century the firm had gained considerably in stature. It took on a policy early on to only act as the sole provider of credit to a given client. By 1803 Barings was appointed general agent for the US Government, arranging payment of interest, purchasing armaments, etc. The same year Barings participated, together with its partner Hope & Co., in financing the Louisiana Purchase, its biggest transaction up till then. The firm was also involved in arranging Spain’s payment of the annual subsidy to Napoleon under the Treaty of Spain (1803). Francis Baring, had, during his 40 years’ reign, transformed Barings from a merchant house to a first-tier bank. It was in these tumultuous years at the beginning of the 19th century that merchant banking took off. Merchant families, emigrants to England from Prussia, France, Ireland, Russia, Italy and America, formed the core of this development. They started out from expertise in trade and commerce, were small family-owned, and managed their houses with limited capital. They provided an essential link between commercial centres of the world. International trade was their business in spite of remaining mercantilist sentiments. Their reputation and connections with agents abroad also made them suitable as intermediaries. Since they knew both parties in a transaction they could accept Bills of Exchange. Merchant banks like Barings, Hambro, Brown, Kleinworth, and Schroder ran very large acceptance books, while others like Rothschild and Peabody & Benson were active at trading bills at a discount in the market. Bills for payment in London and the USA generated a market of currency exchange, and trusted clients could be provided with letters of credit. Merchant banks, knowing their clients well, had an advantage in judging creditworthiness. During this century foreigners also started to issue loans in London (railways, sovereign debt), which needed underwriters to arrange things. As Barings increased its operations in the next few decades, it often met its rival N.M. Rothschild in competition. Barings was larger than most houses in London but remained well behind Rothschild by the mid-1820s. In order to expand operations in the US Baring hired Thomas Ward to be its resident agent in 1830. He extended long term credits to American merchants with business in the Far East and West Indies. A family member (John) had already moved to Boston in 1826 to set up a partnership with Joshua Bates, focusing on the cotton trade. This partnership was soon absorbed into Barings and a new office was set up in Liverpool to engage further in the British end of the cotton trade. The Hambroe family, with roots in Hamburg and Copenhagen, established itself in London during this time, in similar business but specializing in the Scandinavian countries. Kleinwort came from Hamburg like Schroder. Warburg did not set up business in London until in the 1930s, but was already an agent for Rothschild in Germany. Having shifted more of its business toward the USA in the period 1830– 1860, and expanding, meant that Barings became a major participant in Federal, State, and railway loans there, but it also assisted in loan issues for Russia,

84

Transition from State to Market regulation

France and Brazil. It further increased its portfolio of acceptances. Especially the financing of trade in the Far East was lucrative. However, the death or retirement of leaders of the bank exposed it to considerable reductions of its capital as a consequence of withdrawal of funds. Approaching the 1870s the Barings reorganized because the number of partners had doubled, and a merger with a Scottish bank had been undertaken. Business had become complex. Barings chose to concentrate its business in the Americas and the Far East, but unlike other merchant banks, it could not resist further efforts to finance domestic industry. Two issues brought the bank down; a syndicated loan to Manchester Ship Canal was only subscribed to 18%, leaving the participating banks to take up the balance and tie up capital for a long period. An ill-advised investment in shares and debentures of the Buenos Aires Water Supply and Drainage generated a liquidity shortfall in 1890. Under the leadership of the governor of the Bank of England a successful rescue package was negotiated. Edward Baring, leader of the bank up to the crisis, was forced to resign. The bank was reconstructed (provided with new capital from the outside), now as a limited liability company, with only two family members holding stock (20%). However, this reconstruction did not prevent the Baring family from repurchasing voting shares from the new shareholders – mostly banks that had contributed to the rescue package – and within five years they held all voting shares and were again in control. The first priority then was to get rid of the illiquid Argentinian assets and soon it was back to its traditional business; acceptances, investments, and new issues. In the early 1900s Baring discussed a merger with J.P. Morgan, but in the end Barings decided to develop its own subsidiary in New York, run by Hugo Baring. However, Hugo started out disastrously and was soon replaced. In 1908 Barings decided to close down its New York office and work with Kidder Peabody instead. Barings had come through the 1890 crisis with prestige lost and lessons learned. As the First World War approached the bank was again in business as usual, although more conservative than before. The Barings setback provided N.M. Rothschild with an opportunity to consolidate its position as the top merchant bank. At the start of the First World War “Barings’ operations had effectively come to a halt” (Banks 1999, p. 250). Core operations were limited to arranging payments and maintaining relationships. A new manager (Peabody, a Canadian) from the outside was recruited at the end of the First World War and served up to the end of the Second World War. The acceptance business was gradually rebuilt after the first war (tripled in three years), but Barings also focused on building a domestic issue capability (which required a reach out over the whole country). Corporate finance and advisory work became new sources of revenue. International loans were much reduced between the wars. Merchant banks in decline Merchant banks had to respond to these changed circumstances after the Second World War. There were about 40 of them by then in London. The

Transition from State to Market regulation

85

strategic options ranged from growth by acquisition to specialization to narrow niches. Barings’ choice was to expand its domestic presence and seek a more diversified base of revenue. It made progress in line with this (asset management, bond trading, Mergers & Acquisitions), but was considered a bit conservative. More managers were recruited from the outside. Foreign new issues declined during the 1950s but Barings took a leading role in bond issues for British corporations. An asset venture management team (Henderson Baring Asset Management) was organized and was very successful. In 1975 it won the mandate to assist in managing part of the vast petrodollar investments of Saudi Arabia. Another success area was M&A, which offered opportunities to participate in the de-nationalization of industries like British Steel. In 1960 the bank earned a reputation through its defence of Courtaulds against a hostile bid from ICI. Its list of clients grew after this. (The decline of the merchant banks in general (and Rothschild in particular) came with the realization of a decline in capital due to poor business conditions after the war. The family business type of firm also suffered due to death duties as family members die and estates are distributed. Different measures had to be taken to protect the company. In the case of Rothschild, the solution was a holding company (Rothschild Continuation Holdings) making it private. A similar development happened to Kleinwort, burdened by a large portfolio of non-performing credits. Hambro became a limited company too. All merchant banks started to hire professional managers from the outside. Barings entered the 1980s as a top-tier bank but with a somewhat conservative reputation. Pioneering new activities was not to its taste. It was business as usual for the first part of the decade, but by 1984 it had bought a 30% stake in a jobber (Wilson & Watford), and later the same year it was eager to acquire the City’s top broker (Cazenove), but negotiations failed and Barings chose to hire a 15-man team from another broker instead. This team was specialized in the Asian equity markets. Since Barings itself had started trading in Japanese Eurobonds that same year it seemed logical to try to find more business there. Japanese Eurobonds, with attached equity warrants, had become increasingly popular, generating a handsome profit. From a balance sheet of 276 million GBP in 1977 Baring had grown to 2.7 billion GBP at the end of the 1980s. Baring Securities contributed 50% of the profit and employed 1,000 staff. But as the Japanese market became more difficult in the early 1990s – decline in the Nikkei – a greater amount of Baring’s warrant business became proprietary, rather than for clients, in nature. Risk increased with this. All merchant banks faced challenges. Hambro entered the 1980s as a fullservice merchant bank. However, it failed to reach a top position in corporate finance. It purchased 30% of a broker and acquired a small American investment bank, however, as a consequence of the 1987 crash, it narrowed its focus to commercial banking, retail investment service, M&A, and left the equity and government bonds markets. Rothschild retained a conservative business approach focusing on its traditional strength, corporate finance, bullion dealing,

86

Transition from State to Market regulation

export finance and new issues, while avoiding areas where it lacked expertise. Rothschild had difficulties with access to capital since existing partners did not want to dilute their ownership interests. Still it grew into dominance in international and domestic mergers and was successful in building its asset management business. It purchased parts of a jobber and a broker, to build a securities service, and set up office in financial centres around the world. At the end of the decade it stood securely as a significant niche player. Kleinwort gained prominence over the 1980s by demonstrating its capability to manage complex deals in important privatizations and M&As. Kleinworth Benson managed (barely) to carry out an issue of new stock in October 1987 – bad timing in relation to the crash. It also suffered from great variations in profit. Morgan Grenfell severed relations with its previous shareholder and partner, J.P. Morgan. Instead Deutsche Bank acquired a 5% stake. Top management hesitated (due to limited capital) about how to build a securities department, and by the time they had made up their mind, most top tier brokers and jobbers were already spoken for. It bought minority shares in a broker and a jobber and took full control of them after the Big Bang. Over the decade Morgan Grenfell won a top position in M&A, but also a reputation for not abiding fully to the code of conduct in M&A – the Guinness/Distillers takeover 1986/87 was a scandal with several senior managers of Guinness arrested for improprieties, and Morgan Grenfell lost several clients. All the merchant banks had complex strategic problems to deal with after the Big Bang. Barings entered the 1990s with three business divisions; Baring Brothers (merchant banking/corporate finance), Baring Securities (securities sales and trading), Baring Asset Management (investment managing). It chose to expand into new areas (like asset swaps, asset repackaging, arbitrage, and derivatives trading) and new markets (like Latin America and the Far East). Baring Securities, with its earlier success in Japanese warrants, began to decline in importance (losses in 1991 and 1992). In 1993 Barings restructured by integrating Baring Brothers and Baring Securities into Baring Investment Bank. Heath, the “creator” of Baring Securities, left the company. The managerial challenge now was to manage the different cultures within the company. In an effort to improve its American presence Barings acquired 40% of the US investment bank Dillon Reed in 1990. This was increased to majority in 1992, and later full ownership. Baring joined with Abbey National – a building society that had been converted to a bank – to set up a joint venture dedicated to derivatives trading. Abbey National brought a good credit rating to the venture, which had some success for a while. Barings’ Singapore office was the place where the notorious irregularities, which in the end led to the collapse of the entire bank, emerged. Nick Leeson, who had been a trader there since 1992, used the weak control systems to establish very large positions in Nikkei index futures and options, Japanese Government Bonds futures and options, and Euroyen futures. Leeson’s official job was to execute index arbitrage programs (buying baskets of stocks that comprised the index and selling the equivalent index futures. A rather boring

Transition from State to Market regulation

87

job dealing with negligible risk if done properly, one might think.) The cheating was possible since Leeson was also his branch’s (internal) auditor (Soll 2014, p. 123), and could cover up trading losses by booking (hiding) them to an error account – a so-called 88888 account – that was not monitored by auditors. Leeson thus had effective control of back office functions, which was not in accordance with accepted practice. It was the Kobe earthquake of January 1995 that exposed Leeson. He had bet on the Nikkei remaining calm, but the earthquake caused the market to fall and remain volatile for some time. Losses mounted and Leeson fled the company. Barings had to call in the Bank of England and other regulators to consider the consequences of the situation. Other banks negotiated a rescue package of 500 million GBP, but when news came that losses would be larger than 650 million the plan failed. A take-overoffer from the Sultan of Brunei also fell through. There were too many openended contracts to assess the value of the company properly. Unwinding its business Barings uncovered a loss of 860 million GBP. In the end the ING bank bought the whole operation for 1 GBP. Baring’s internal control infrastructure was inadequate – only in January and February of 1995 Barings had paid 570 million GBP in margin calls; 25% of this one week prior to the collapse. ING integrated Barings with its own investment banking business, which was of considerable size, and by 1997 ING closed down large portions of its emerging markets activities (where Barings had been strong). The other merchant banks had similar problems; Hambro called in consultants who suggested that the bank should be sold as an entity, but the bank chose to sell itself in pieces (after 158 years). Warburg, Kleinworth Benson and Morgan Grenfell were sold as whole units. Rothschild was one of the few merchant banks that remained independent during the 1990s. It managed to maintain a revenue stream that was mainly fee-driven, and entered into cooperation with the Dutch ABN AMRO bank. After the Barings failure it reviewed its organization and control systems. The bank was restructured on a global basis, with Rothschild Continuation Holding as the centre, and chose a successful niche strategy. 3:5:3 The business model of Barings through the storm of events of the 20th century It would seem that a merchant bank like Barings was doomed when nationalism and State control increased in the run-up to the First World War, dependant as it was on international trade. Still Barings kept up a valiant struggle for survival, searching for a niche with good prospects. The British Empire must have been seen as the safe haven to choose as its home territory, and – remember Bagehot’s (1873, p. 2) words about London being the most moneyed city in the world. Further, strategies were simple in the sense that the organization was small and agile (as mentioned Barings had 71 employees by 1903), and business was closely related to politics. Barings was well connected.

88

Transition from State to Market regulation

But, after the Second World War conditions changed. The British Empire was challenged on many fronts and started to fall apart, old connections lost value, new structures were established to cater for a new kind of globalism, with (groups of) nations as actors. Welfare States were built. With skill and a reputation as a conservative bank Barings managed fairly well to find opportunities to exploit, like the petrodollar, without much change of the business model. When de-regulation came with “the Big Bang” as a desperate effort by the Thatcher government to regain some of the lost territory as a financial centre for London and Britain, Barings found itself in rough seas. Not only had large organizations entered the London scene, but the name of the game was to complement existing organizations with services that had heretofore been incompatible with banking (insurance, jobber, traders, etc.) due to regulations. Everybody, especially smaller units, were now potential targets for take-over bids. Closely held companies like Barings could not relax. They had to find ways to grow to be able to defend themselves against take-overs. The alternative, to maintain close family control, doomed the merchant banks to a constant capital inadequacy. This was too much of a challenge for such a small management team. Mistakes were made, capital was lacking. Doing a little of everything to spread risks in these turbulent times was not a viable strategy. Growth in number of employees and business units had been done too quickly, without adequate control mechanisms and system support. Had de-regulation been carried out in a more modest tempo, Barings could have found time to design a viable strategy for the new times. But now it was “market solutions” that carried the day in politics (Thatcher and Reagan). There had been a revolution in the context of financial actors. The options were too numerous and the capacity to act limited. Barings was trapped in a strategic stress syndrome. It had to do more than it could manage in a short time.

Notes 1 The reader should contemplate whether there are other occasions, like the present one, where these criteria are also met. 2 “Principles” will be discussed in the concluding section of this chapter.

References Azpilicueta, Martin de (1556) Comentario resolutorio de cambios. Salamanca Bagehot, Walter (1873) Lombard Street – A Description of the Money Market. London: King & Co. Banks, Eric (1999) The Rise and Fall of the Merchant Bank: The Evolution of the Global Investment Bank. London: Kogan Page Bentham, Jeremy (1789) An Introduction to the Principles of Morals and Legislation. Cameron, Rondo (ed.) (1972) Banking and Economic Development – Some Lessons from History. New York: Oxford University Press Chandler, Alfred D., Jr. (1962) Strategy and Structure: Chapters in the History of the American Industrial Enterprise. Cambridge, MA: MIT Press

Transition from State to Market regulation

89

Gerschenkron, Alexander (1962) Economic Backwardness in Historical Perspective: A Book of Essays. Harvard, Cambridge, MA: Harvard University Press Heckscher, Eli F. (1931/1935) Merkantilismen: ett led i den ekonomiska politikens historia. Stockholm: Norstedts. (Two volumes – English version Mercantilism trans. by Mendel Shapiro. London: Macmillan) Keynes, John Maynard (1936) The General Theory of Employment, Interest and Money. London: Macmillan Magnusson, Lars (1999) Merkantilismen – Ett ekonomiskt tänkande formuleras. (English: Mercantilism – Economic Thinking is Formulated) Stockholm: SNS McCloskey, Deirdre N. (2006) Bourgeois Virtues: Ethics for an Age of Commerce. Chicago: Chicago University Press. McCloskey, Deirdre N. (2010) Bourgeois Dignity; Why Economics Can’t Explain the Modern World. Chicago: University of Chicago Press McCloskey, Deidre N. (2016) Bourgeois Equality: How Ideas, not Capital or Institutions Enriched the World. Chicago: Chicago University Press Mill, John Stuart (1843/1882, 8th ed.) A System of Logic, Rationative and Inductive, being a Connected View of the Principles of Evidence and the Methods of Scientific Investigation. New York: Harper & Brothers Mill, John Stuart (1848/1885 (abridged version)) The Principles of Political Economy. New York: Appleton & Co. Mun, Thomas (1664) Englands Treasure by Forraign Trade. or The Ballance of our Forraign Trade is The Rule of our Treasure. London: Clark Schumpeter, Joseph (1954) The History of Economic Analysis. London: Allen & Unwin Soll, Jacob (2014) The Reckoning: Financial Accountability and the Rise and Fall of Nations. New York, NY: Basic Books Smith, Adam (1759) The Theory of Moral Sentiments. Edinburgh: Millar Smith, Adam (1776) An Inquiry into the Nature and Causes of the Wealth of Nations. London: Strahan & Cadell Streeck, Wolfgang & Philip C. Schmitter (eds) (1985) Private Interest Government: Beyond Market and State. Beverly Hills: Sage Sweezy, Paul M. (1946, 2nd ed.) The Theory of Capitalist Development – Principles of Marxian Economy. New York: Monthly Review Press Viner, Jacob (1954) Schumpeter’s History of Economic Analysis: A Review Article. American Economic Review. Vol. 44, pp. 894–910.

4

Market as ideology – toward the financial crisis of 2008

4:1 The need for economic policy production increases For Barings, the merchant bank that had prospered with the rapid economic development during the 19th century, the wars brought much tighter State control of all kind of economic activity, but the post-war period was not easier. It provided more new dimensions to deal with than before. It was also a new era of contested economic policies, Keynesianism vs monetarism in the spirit Friedman; there was the renewed struggle between unions, labour vs liberalism; and the cold war was casting its shadow. (“From Stettin in the Baltic to Trieste in the Adriatic, an iron curtain has descended across the Continent”, Churchill had said in 1946.) The policy issues were so numerous and resources so scarce that the design problems for Europe (or for the world) were overwhelming. Much like after the previous war, economists and other scholars felt a need to discuss ways to apply their scientific achievements to the practical problems at hand. After the previous war, groups of scholars tended to work on a national basis, like the economists in Vienna under Ludwig von Mises leadership. This time the reasoning was more about generally applicable principles. With the famous controversy between Keynes and Friedman about the wisdom of State intervention to push business cycles in the right direction in mind, a group of economists gathered in Swiss Mont Pélerin at the invitation of Friedrich von Hayek in 1947 to discuss what was now required. The purpose, stated by Hayek, was to find ways to promote freedom, market solutions, and free trade (against the threat of a creeping socialism disguised as welfare economics). This was a new phenomenon in the sense that economists with a certain theoretical orientation organized to influence policy issues in a complex world with many contradictory tendencies. Haas (1992) gave this phenomenon a name: “epistemic communities”.

4:2 “Epistemic communities” step in to set the agenda (neo-liberalism and libertarianism) A prominent insider in US neoconservative circles, Edwin J. Feulner of the Heritage Foundation, has felt compelled to clarify the usage of the term “neo-liberal”

Market as ideology

91

in the USA. He maintains that the neoliberal intellectuals’ Mont Pélerin Society was founded to uphold the principles of what Europeans call ‘liberalism’ (as opposed to ‘statism’) and what we Americans call ‘conservatism’ (as opposed to ‘liberalism’): free markets, limited governments, and personal liberty under the rule of law. (Feulner 1999, p. 2) Haas (1992, p. 3) defines an epistemic community as a network of professionals with recognized expertise and competence in a particular domain and an authoritative claim to policy-relevant knowledge within that domain or issuearea. Although an epistemic community may consist of professionals from a variety of disciplines and backgrounds they have 1 2

3 4

a shared set of normative and principled beliefs, which provide a valuebased rationale for the social action of community members; shared causal beliefs, which are derived from their analysis of practices leading or contributing to a central set of problems in their domain, and which then serve as the basis for elucidating the multiple linkages between possible policy actions and desired outcomes; shared notions of validity, that is, intersubjective, internally defined, criteria for weighing and validating knowledge in the domain of expertise; a common policy enterprise, that is a set of common practices associated with a set of problems to which their professional competence is directed, presumably out of the conviction that human welfare will be enhanced as a consequence.

What was the problem that these invited economists were supposed to deal with, and where did the ideas of a solution come from (the heroic struggle of the Red Army, with the millions of lives lost was a basis for political/socialist propaganda, and all European States were already under very strict regulation due to war conditions)? A two-pronged, neo-liberal epistemic community was formed to promote a certain kind of economic policy when nations were to be re-built after the Second World War.

4:3 The roots of neo-liberalism The neo-liberal movement has its roots, no doubt, in Austria, and has to do with the new thinking that was required to find a way to re-establish a “good” society after Austria’s devastating defeat in the First World War. In time, at the end of the Second World War, there was enough of a common understanding among many economists to meet the requirements spelled out by Haas (1992) to form the Mont Pélerin Society – an epistemic community – scholars as activists. To support this argument, I will try to give a coarse picture of the

92

Market as ideology STATE “Hierarchical Control”

“Theory/Debate”/ Principles “Theory/Debate” “Neo-liberalism” “Libertarianism” Practices

Principles

MARKET

COMMUNITY

“Dispersed competition” Icelandic banks

“Spontaneous Solidarity”

RBS

Figure 4.1 Market as “ideology”

intellectual situation at that time in Austria, and then portray some of the most visible participants in the debate and some of their ideological texts. The task will then be to trace the path of these ideas to Western Europe and the USA to see if and how they were distorted or “translated” on their way to current beliefs in markets, freedom of the individual, and disdain for the State. The most important carrier of the message was, probably, Milton Friedman of Chicago, but Friedrich Hayek of, first Vienna, and then Chicago, was the initiator. It started in Vienna. 4.3.1 Modernism and crumbling empires1 The action when it comes to neo-liberalism and neo-classical economics started in Vienna, Austria, when modernism found a new articulation in science, technology and industrial enterprising in the world toward the end of the 19th century. Austria responded to the challenge somewhat differently from many other major powers. While France and Great Britain could embrace modernism and keep their (overseas) empires, landlocked and agricultural Austria saw real estate expansion to the south east as its solution. Serbia represented only one of the nationalist movements that bothered the Emperor of this multi-national creation. Newly formed Germany/Prussia, also a strong State, but with more elaborated

Market as ideology

93

hierarchical/military control, embraced science and technology, and thought of expansion as well. Russia, with its vast tsarist empire, did not bother too much with planning but with honour and with keeping the new socialists at bay. The world had prepared for the First World War for some time. As that war approached, Austria already had the problem with Serbia to deal with and had its eyes on the south-east. Its natural ally, Prussia, did not trust Austria with much information after a tsarist spy had been exposed (by Prussia) at the military headquarters of Austria, and Italy soon dropped out of the entente. So, the Prussian plan to strike quickly at Paris and then deal with the tsar, as well as the Austria’s plan to take on Serbia (soldiers with recent war experience) and then attend to its Polish territory, did not go so well. The failure was most devastating for Austria, the empire was dissolved, and Austrians had to re-invent their nation. For Russia the Bolsheviks took over the revolution and to manage their new nation they had to redesign Marx’s theory, establish the State on the basis of a new economic order for agriculture and hope for industrial workers to join in as they grew in numbers. Revolution, in one nation, could be managed with strong central coordination from the State. Spreading the revolution to other countries was not as easy as the original socialists had imagined, but it was the main option as soon as State coordination in the name of equality among all citizens had been established. The traditional Western alternative to coordination by the State through planning, was to let the economy and emerging industries grow through Darwinian competition. Factories would pop up and generate lots of jobs and prosperity would come even if one could not say where or when. The controversy as to the nature of proper science (was Freud a proper scientist?), as well as how to organize a good society, preoccupied intellectuals in cafés, private seminars, and universities in Vienna (Janik & Toulmin 1973). Two philosophers, notable from a present-day perspective were young Viennese by the time of the First World War, namely Karl Popper and Ludwig Wittgenstein. Karl Popper, known for his work on the demarcation problem (what is scientific and what is not) and his thesis that science progresses by error elimination (falsificationism), was a young socialist who saw school friends killed by police in violent demonstrations at the time of the First World War. He changed his mind about the proper basis for building a good society. In spite of difficulties in school he managed to take a university degree and landed his first teaching job in New Zealand in 1937, where he started to write his book in defence of liberalism (The Open Society and Its Enemies, published in London in 1945). This book was a by-product of Popper’s earlier work on The Poverty of Historicism, a critique of the social sciences and the impossibility of making scientific predictions to be tested in this area. Given that historicism is untenable, we should not place our hopes in the ability of central authority to coordinate, predict and plan the development of a good society. In gathering material for the book on historicism Popper also assembled the philosophical arguments (starting with Plato) for the idea of an elite that could plan for us from a centre

94

Market as ideology

of power. The ideas of those philosophers formed the structure of Popper’s Open Society and Its Enemies. There simply is no basis for believing in central planning. From New Zealand Popper was recruited to the London School of Economics. Ludwig von Wittgenstein grew up in the most prominent family in Vienna. His grandfather was an authoritarian that refused to let his son Karl (Ludwig’s father) study engineering (not suitable for a person in his position). Karl rebelled, went to the USA and worked in menial jobs, was later reconciled with his father, and allowed to study. Karl became a leading industrialist through “industrial rationalization” and the leading patron of art in town. His attitude toward his children was authoritarian too, however, and Ludwig was taught at home until 14. When he entered the technical school in Lienz he got in contact with Hertz’s Principles of Mechanics. He showed an early talent for constructing things. Leaving school for university studies, Wittgenstein had hopes to learn from Ludwig Boltzmann, but those hopes were frustrated by the suicide of his scientific idol in 1906. Wittgenstein also experienced the suicides of three of his brothers, two of them while in opposition to their father, and one facing capture at the Italian front during the war. Family catastrophes added to the controversies in the academic world. Wittgenstein published Tractatus Logico-Philosophicus (1921), after having failed to persuade several publishers of its merits. It was a determined effort to reconcile the language problems between ethical and scientific discourse in Vienna circles. Janik & Toulmin (1973) argue that Tractatus is an exercise in ethics and draw our attention to the last part, which Wittgenstein intended to be the climax of that book, but which was looked upon as an insignificant addendum by contemporaries like Bertrand Russel. Wittgenstein’s main work by current standards is Philosophical Investigations (1953), which has had a fundamental effect on social sciences in terms of the “linguistic turn” that many of them have adopted (not economics however). However, even if Wittgenstein was present at the time in Vienna, his exotic behaviour distanced him from the core of the new “modern” grouping of scholars. The Austrian schools Already before the war, Austrian intellectuals had been pushed into action by the obvious lack of tenability of the Austrian-Hungarian imperial life style. The “Vienna Circle”, a gathering of philosophers, humanists, artists and journalists (Janik & Toulmin 1973), found reason to question most of the fundamental principles of social life and articulate new world views. Economists debated the foundations of the market economy in opposition to the failed State coordination of people’s life. Kaiser Franz Joseph ruled according to the principles of “Ruhe und Ordnung” (Quiet and Order). He had come to power in 1848 at a very young age amidst the revolutionary movements at the time, and allowed no change. A proper railroad system could not be built because it might promote revolution. To his death, the royal palace was lit by kerosene lamps. The

Market as ideology

95

military also had to be kept on tight reins, and was allocated its (meagre) resources, not to become too powerful, by royal decision (Hausmacht). Austrian administration had degenerated into formalism that was only a façade – Franz Joseph did build a number of impressive buildings, however, with impressive facades in Vienna – to cover up chaos and contradiction. Vienna, was known as the City of Dreams, and for its Strauss waltzes, chic cafés, and pastry. You could sit all day with a cup of coffee and read newspapers from all over the world – and discuss matters. Vienna was a very bourgeois town in a crumbling multinational empire. To escape dark thoughts about revolutionary developments the bourgeoisie attended to the upkeep of appearances. The intellectuals found it necessary to get rid of a language use that tended to obscure realities and prevent a more realistic building of a good society. One line of reasoning in this “Sprachkritik” before the war had landed in the conclusion that “the meaning of life” is not a matter of rational debate, it cannot be given an “intellectual foundation” (a position held in common by such giants as Schopenhauer, Kirkegaard and Tolstoy). It is mystical in a sense and can only be “shown” as Tolstoy did in stories (“Twenty-three Tales”). The alternative line of reasoning was that of Mach, further developed by Hertz and Boltzmann, where you base the analysis in general principles external to the subject at hand, i.e., keep the rigorous language of a particular science and depict a phenomenon in mathematical models (instead of metaphors), which, applied in the proper way, can yield true knowledge – this could be extended to all sciences, and to society. The problem that remained, given these two positions, was “Is there any method of doing for language-in-general what Hertz and Boltzmann have already done for the language of theoretical physics?” (Janik & Toulmin 1973, p. 166). This is where Wittgenstein’s Tractatus comes in. It uses a language of logical propositions (or rather aphorisms) to argue that ethics cannot be dealt with in the same way as the sciences. There is no “rational” basis for ethical statements. They can only “show” their meaning. By separating reason from phantasy – the mathematical representations of the physicist, from the metaphors of the poet, descriptive language from “indirect communication” – Wittgenstein thought that he had solved the problem of philosophy (Janik & Toulmin 1973, p. 198). He was recognized as a genius by G.E. Moore (Wittgenstein became the successor of Moore at Cambridge) and Russel, who were on the same kind of crusade against the abuse of language of the Victorian age in Britain, but they used the term “analytical philosophy” (propositional logic). Wittgenstein, however, felt misunderstood by Russel but failed early on, and kept failing to articulate how Russel had misunderstood. He also failed to participate constructively in a discussion with the Vienna circle representatives on propositional philosophy (that would support their work on a “unified science”). He actually insisted on reading poetry to them. It seems like he could not articulate the meaning of ethics “showing” itself via indirect communication, which the last aphorism of the Tractatus (6.54) seems to encapsulate:

96

Market as ideology My propositions serve as elucidations in the following way: anyone who understands me eventually recognizes them as nonsensical, when he has used them – as steps – to climb up beyond them. (He must, so to speak, throw away the ladder after he has climbed it.) He must transcend these propositions and then he will see the world aright.

Again, the ethical statements (goals and values) must “show” their meaning. They cannot be understood by deductive reasoning. (They cannot be “calculated” into utility measures in the spirit of Bentham, which already Moore and Russel found inadequate and vulgar.) Popper, on the other hand fitted nicely into the positivist thoughts about what constituted science. It was a tradition in Vienna to set up “private” seminars. Out of some of those arose two groupings of significance for the development of a social science theory: the Vienna circle and the Austrian school in economics. The “Vienna circle” (Der Wiener Kreis) went public with a manifesto in 1929 where a group of scientists with Otto Neurath, Rudolf Carnap and Hans Hahn as the leading names. The scientific world view promoted in the manifesto is mostly known as “Logical empiricism” (or positivism). It is the dominating view in social sciences (incl. Finance theory) today. Its name describes its main tenets; there is a world, separate from us, that we can obtain sense data from (by observation or experiment). Further, only propositions that can be analysed by the tools of logic into elementary propositions (that are either tautological or empirically verifiable) can be said to be meaningful. Logical empiricism therefore rejects metaphysics, theology, and, sometimes, ethics as meaningless. The boundary between scientific and non-scientific approaches was an area of contention also between members of the Vienna circle. It should be noted that a “left wing” in the Vienna circle, led by Neurath, argued that society itself could also be improved by applying scientific methods to its problems. State (imperial) or Market as the principles of coordination of social and economic life, was on the agenda already before the war. Ludwig von Mises Von Mises was born in the city of Lemberg (now Lviv) in current Ukraine. Entering the University of Vienna at the turn of the century, as a leftist interventionist, Mises was converted to the Austrian school as he discovered Principles of Economics by Carl Menger, with its emphasis on individual action rather than unrealistic mechanistic equations as the unit of economics analysis, and to the importance of a free-market economy. As a post-doctoral student at the university of Vienna Mises was also inspired by von Böhm-Bawerk, who had disproven the Marxian labour theory of value. During this period Mises was recognized for The Theory of Money and Credit (1912) where he integrated the theory of money into the general theory of marginal utility and price, i.e., micro- and macro-economics. This was not accepted in the Austrian school,

Market as ideology

97

however, so he chose to go “in opposition” arguing for a neo-Austrian approach. His theory claimed that an increase in money supply was not beneficial for society since that increase would generate bank credit expansion and therefore inflation and business cycles in the form of overinvestment in “higherorder capital goods” rather than consumer goods. The credit based, inflationary boom requires a painful recession while the market liquidates unsound investments to re-establish a connection with “real” consumer demands (think of the banks in Seville). Mises, and his follower Hayek, developed this cycle theory during the 1920s, on the basis of which Mises was able to warn an unheeding world that the widely trumpeted “New Era” of permanent prosperity of the 1920s was a sham, and that its inevitable result would be bank panic and depression. When Hayek was invited to teach at the London School of Economics in 1931 – by an influential former student at Mises’s private seminar, Lionel Robbins – he was able to convert most of the younger English economists to this perspective. On a collision course with John Maynard Keynes and his disciples at Cambridge, Hayek was quite critical of Keynes’s General Theory in a review. But he could not stem the tidal wave of the Keynesian Revolution that swept the economic world after its publication in 1936. From now on Mises was strictly in opposition to this new global fashion in macroeconomic policy. Already in 1920 Mises had published an article, “Economic Calculation in the Socialist Commonwealth” (1920), in which he demonstrated that it would be impossible for a socialist planning board to plan a modern economic system. Furthermore, no attempt at artificial “markets” could work, since a genuine pricing and costing system requires an exchange of property titles, and therefore private property was needed, also concerning the means of production. Von Mises can be said to be one of the leading laissez-faire free marketers of his time. Friedrich von Hayek Nowadays often referred to as Friedrich Hayek he received doctorates in law and political science in the early 1920s from the University of Vienna. He soon became a protégé of Ludwig von Mises and was hired by him to work as a specialist on legal details of the Treaty of Saint-Germain (containing the Covenants of the League of Nations). Again, with encouragement from von Mises, Hayek founded and directed the Austrian Institute of Business Cycle Research from the late 1920s until he was recruited to the London School of Economics (LSE) in 1931. At LSE he was recognized as a leading scholar in the development of micro economics. Notable is his debate with Keynes on the benefits of private investment in the public markets as a better policy than Keynes’ public sector deficit spending to improve employment. (On other matters, they were in agreement.) While at LSE Hayek taught many economists that later reached influential status (like Ronald Coase, Kenneth Gailbraith, Nicholas Kaldor, Oskar Lange and many others). In 1950 he moved to the University of Chicago where he stayed until 1962, when he returned to

98

Market as ideology

Germany (University of Freiburg). He had a profound influence on Milton Friedman while in Chicago, not least via the meetings of the Mont Pélerin Society (named after the place of the first meeting in Switzerland), which was initiated at the invitation of Hayek in 1946. The Society is still active today as a liberal defender against the arbitrary application of power to impose collectivist solutions to social problems. It should be noted that at the first meeting of this Society Ludwig von Mises was present, but he left early angered by the conservatism of the participants, slamming the door. As mentioned, Hayek left LSE in 1950 for the University of Chicago. However, he was not employed by the Economics department but at the Committee on Social Thought and worked on political theory, not economics. He was critical to the positivist approach of the Economics department. Ideologically, however most of the Economics faculty were in agreement with Hayek. Milton Friedman, a friend of Hayek’s and co-founder of the Mont Pélerin Society, was quite critical of Hayek’s economics writings, however. Hayek focused on the constitution of liberal society and wrote the Constitution of Liberty, which was published in 1960. He was disappointed that it did not receive the same attention as The Road to Serfdom had in 1944. Milton Friedman had taken over as the most visible promoter of neo-liberal economics at the time. The Road to Serfdom The Road to Serfdom (Hayek 1944) is written as an argument for a market-based, post war, social order. It is inspired by the Austrian school of economics and chiefly argues against centralized planning, and for market solutions. The problem that comes back again and again is that a powerful State organization can be an effective instrument for inflicting damage on friends and foes alike since the myth of coordination for the common good is a real myth because there simply is no way to consider all the different goals and desires of all individuals at the same time. The cognitive/computational task is too large even if one were to have updated information on the wishes of all people. Consequently, since there will have to be prioritization between values and goals on an arbitrary basis, the planning ideology will always have devastating moral effects (unless planning is done on the local level and among groups who are in agreement on desired outcomes). Hayek wrote this text during the war as part of the debate on the post war organization of society. At that time admiration for the resilience of the Soviet Union was helpful in the promotion of the socialist alternative. Hayek provides an analysis of various aspects of the planning option in 16 relatively short chapters. One should remember that Hayek had a much-publicized debate with Keynes on the role of the State in promoting “full employment” in the 1930s. Then Hayek had questioned the idea of the State using deficit spending to promote growth. This (the business cycle) was Hayek’s area of research during his time in Vienna.

Market as ideology

99

Hayek starts out by claiming that step by step we have allowed the ghost of totalitarianism to spread across Europe. Collectivism – the opposite of individualism, the hallmark of the liberty that bloomed with growth in the 19th century – is gaining ground. “Organization” and “planning” have replaced the ideas of making use of the spontaneous forces in a free society. German intellectuals like Friedrich Hegel, Karl Marx, Gustaf von Schmoller, Werner Sombart and Karl Mannheim laid the foundation for this dangerous way of thinking. That new, great utopia of socialism is a “new freedom” that promises to rectify the inequalities and injustices that uncontrolled capitalism has generated. The progressive forces of society will create a more egalitarian distribution of wealth. For this to happen gaining political power is the first step, since the tool for the new freedom is coordination from the centre and planning. Nazis and communists are varieties on the same root, collectivism, and they used to confront each other in Italy and Germany in the 1920s and 1930s. Hayek points out that it was the old socialists, oriented by class and based in trade unions – workers against capitalists – that set the game up by finding it relatively easy to reach agreement with employers on work conditions for organized, trained workers. This left the untrained out and that was the ground for Nazism and Italian fascism. One should remember that the (social democratic) socialists were the main enemy for these new movements that took over. They, both in the Soviet Union as well as in Nazi Germany, used their power to re-distribute privileges and wealth as a small elite saw fit. A return, after the Second World War to a democratic socialism built on planning is not possible, according to Hayek, because central planning can never accommodate all the various values and wishes of individuals. The world has changed and planning is, if anything, less useful. Hayek is quite ideological throughout the book, but also now and then refers to the current debate and published facts. He seeks trustworthiness in his early claim that he has seen the same tendencies develop twice, in his two lives, in Austria and in the Anglo-Saxon countries. Collectivist solutions cannot work because of the calculative problem and because of the impossibility of setting goals. The solution is freedom and free competition. For those that are unlucky there should, however, be a social insurance to ensure a minimum standard. The problem is how to deal with the variations of the business cycle – some economists believe that it could be managed by monetary measures, others that deficit spending in public works with the right timing will work. Hayek evokes the image that all interference with the market system in order to stabilize and create security will generate insecurity. Three arguments are presented why collectivist societies tend to promote their worst members to leading positions: 1

People with higher education and intelligence tend to have more differentiated opinions. Mobilization, therefore, has to turn to the “lower” sections of society. This majority has lower moral scruples. A “strong” man

100 Market as ideology

2 3

with a simple recipe will be believed to be able to improve things. The totalitarian leader talks to them and converts non-believers to these simpler views. The dictator can appeal to people with vague and unfinished ideas. People find it easier to gather around negative slogans (against capitalism, injustices, competitors…). Dividing people into “them” and “us” binds “us” together.

Once in control, the central planners kill the truth in the sense that any expression of doubt or hesitation in executing plans may jeopardize the improvement projects. Therefore, doubts must be looked upon as treason. In time, people will adapt to this attitude and avoid “sticking out” (which is serfdom). In some of the final chapters Hayek compares the roots of socialist and nationalist collectivists and traces them back to the same kind of reasoning, against liberalism, in both camps. Both camps also have the same attitude toward science, claiming that their central planning approach is justified in the name of science. After all, this was a time of increasing respect for scientists and a time when scientists, not least in Germany, claimed to have knowledge that could be applied in the design of the good society. Hayek points to the roots of Nazism in socialism and to totalitarian streaks in the current British debate on society and how these (streaks) tended to eliminate the difference between “society” and “State”. He engages in that current debate by frequent references to the controversies of the day. In the final chapters it is obvious that the fundamental problem Hayek is discussing is how to cope with the problem of prioritizing the multitude of desires, values and goals that people hold. His solution is the market. The market is able to sort all this information out and arrive at solutions. It is not the means as much as the ends that markets can coordinate. Freedom is the freedom for everyone to pursue happiness in their own way. We do not know how a market works – it is his main point that planners and the State could never simulate it – but we should submit to its magic and accept our ignorance about it. Only late in the book does the concept of organization appear. Hayek’s claim is that part of the dealing with a multitude of values and goals is to organize at the right level (compare the principle of subsidiarity applied by the European Union). Monopolies appear in his world of companies, but not large multinational ones. A single goal for all, in the form of, e.g., “shareholder value”, is not present at all, even if he points to the capacity of money to translate between the different ends people might strive for. The Open Society and Its Enemies Popper is most known to social science doctoral students for his theory of science doctrine called “falsificationism”, which states that a proposal is only scientific if it can be falsified. Science progresses via conjectures and refutations, i.e., by intelligent guesswork, and the elimination of error. If claims are not

Market as ideology 101 falsifiable they are not within the borders of demarcation. This “demarcation” borders separate scientific claims from beliefs, religion, and other superstitions. Popper’s ideological work was written after he escaped from Austria in the late 1930s and first stayed in New Zealand for a short period. Then he was recruited to the London School of Economics, where his The Open Society and Its Enemies (1945) was published at the end of the war. He finds the enemies of the open society in some of our most prominent philosophers (Plato, Marx and Hegel) and shows how they went wrong. This is why this book could be classified as ideological. There were critics of Popper too, of course. This is not intended to defend or accuse, just to bring up a few arguments that Popper uses. Let us look at Plato first. Popper points out that Plato reasons backwards from the current situation to earlier times to find his Utopia (the Golden Age), which is a society of guardians (philosopher kings), armed auxiliaries, and the working class. The guardians, it should be noted, are communists. They are not driven by economic gain, but share all (including women and children), and are satisfied by enough wealth. The designers of agency theory (Jensen & Meckling, 1976) must have had those Guardians in mind when they came up with the characteristics (vague as they are) of the Principal, who constantly worrys that her/his underlings, the agents, will deceive her/him.This class cannot be infiltrated by lower classes and is kept clean by breeding and education. The auxiliaries may keep arms, and the workers work. In a later chapter Plato defines justice as fulfilling one’s function in society and happiness follows from this functional view. Stabilizing society is the goal since change is decay. Popper points out, in several passages, that Plato wrote these texts as an ardent opponent to democratic Athens, and in defence of a return to (benevolent) tyranny. An important prerequisite for Plato’s design of the good society is that we distinguish between laws of nature and normative laws (a distinction not upheld by latter day neo-liberals). Natural laws describe a strict, unvarying regularity that holds in nature (then it is true) or not (in which case it is false). If we do not yet know, the statement is a hypothesis. Normative laws are different. They are enforced by man and can be altered by man. They can be described as good or bad, right or wrong, acceptable or not, but they cannot be said to be true or false, since they do not describe facts, but lay down directions for our behaviour. Popper argues that this distinction is necessary for understanding Plato’s sociology (design of the good society). Popper’s critique of Plato’s theory will take him from “naïve monism” (a characteristic of the closed society) to the “critical dualism” of the open society. In naïve monism the distinction between natural and normative law has not yet been made. Unpleasant experiences are the means by which individuals learn to adjust to their environment, whether sanctions are imposed by man or suffered in the natural environment. In critical dualism we uphold the distinction between facts and decisions. But – one might oppose – a decision is a fact once it is taken. Here we need to

102 Market as ideology distinguish between the description contained in the decision and the fact that the decision has been made. Popper illustrates by the statement “Napoleon died in St Helena” as compared to “Mr A stated that Napoleon died in St Helena”. We cannot deduce that Napoleon died in St Helena from the fact that Mr A said so. By the same reasoning we cannot derive a norm, or a decision, or a policy proposal from a sentence stating a fact. The distinction between laws of nature and normative laws is crucial here. Natural – is observable in nature and can be tested against facts. Normative – is made by man (even if unintentionally) and is alterable by man. (To my mind it follows from the claim that normative laws cannot be deduced from facts, they win adherence by reference to values and by persuasion. We need to distinguish between logic and rhetoric. When both the logic and rhetoric are accepted, normative laws gain legitimacy.) A critical moment in Popper’s attack on Plato is his critique of Plato mixing up the meanings of individualism, which are two according to the Oxford Dictionary:  

Individualism as opposed to collectivism Egoism as opposed to altruism

There is no contradiction in an individualist being altruistic. But Plato uses the rhetorical trick of confusing individualism with egoism (as, indeed agency theory does) in support of his collectivist solution for the Good Society. This confusion allows him to use proverbs like “friends have in common all things they possess” to arrive at collectivist conclusions. It also allows him to define justice from the criterion of the interest of the State. That which serves the interest of the collective is just. Those with another opinion should be banished. In a concluding discussion Popper tries to understand Plato by pointing to the current debate at the time of Plato, which focused on the question “Who should rule?” The obvious answer is “the best” or “the wisest”, or “the masters of the art of ruling”, or “the General Will”. But even the most powerful tyrant, once elected, will realize that there are other political forces. The ruler will set up his own secret police. Therefore, we cannot have unchecked sovereignty (compare the US “checks and balances”). The “paradox of freedom” first stated by Plato (What if the democratic majority wants to be ruled by a tyrant?) – that we have to give up some of our freedom to be really free – is taken up by Popper to discuss institutions that may protect us against the mistakes of a bad or incompetent tyrant (rules of governance). To understand Plato coming down on the side of a tyranny of the wise Popper reminds us that Plato is working backwards towards some original (utopian) stage of society – a tribal situation with organic order, intimacy, authority (i.e., community in the terminology of Streeck & Schmitter (1985)). The beginning of decay of Athens came from its opening up to trade, and its expansion across the seas. This brought new forces of change which brought the democratic movement (decay toward chaos).

Market as ideology 103 Popper argues that Plato wanted to design the good society, but he did so by seeking origins and taking inspiration from there. He ended up with a stabilised, collective society and justified this by using rhetorical tricks (like, confusing the meaning of individualism) to define virtues like justice in terms of what is good for the State. Popper’s account of Plato’s organizational design should be kept in mind while reading the case of RBS (Royal Bank of Scotland). Popper gives further critical accounts of how several philosophers came to arrive at models of closed societies, but here Plato’s logic and rhetoric from Popper (1945, vol. I) will suffice. Milton Friedman Milton Friedman is without doubt the most significant representative of activist, neo-liberal design-oriented economics. From the early 1970s he was the driving force behind the advance of the Chicago School and its influence on policy and politics. Two aspects of his activities stick out; his relentless efforts to debunk Keynes, and his firebrand teaching of the blessings of freedom and individualism. He was a founding member of the Mont Pélerin Society movement. Both of Friedman’s parents emigrated from the Hungarian part of the Austrian empire in the 1890s. They met in New York and settled in Rahway, New Jersey, where Friedman grew up. An excellent student, he intended to major in mathematics, but was persuaded to switch to economics by none other than Arthur Burns (who later served as Chairman of Eisenhower’s Council of Economic Advisers), whom Friedman helped by reviewing the manuscript for his PhD thesis. Friedman was charmed by the elegance of Marshallian economics and the analysis of partial equilibria. Friedman received his PhD at Columbia in 1945 on a thesis written with Simon Kuznets on professional practice and the limitations on the number of entrants to professions by the State. He then worked for the government during the early years of the Second World War. Friedman got his first academic job at the University of Minnesota where he joined George Stigler in writing an angry attack on rent control that was published by the Foundation for Economic Education, a lobby organization for “free enterprise”. When Stigler got a job offer from the University of Chicago in 1947, and turned it down, it went to Friedman who accepted. His brother-in-law, Aaron Director, had returned to the same university in 1946 after studies in London where he got to know Friedrich Hayek (at LSE). He persuaded Chicago University Press to publish, Road to Serfdom, the British best seller. Director was, like Hayek, oriented toward Law and Economics and taught antitrust law. The Volcker Fund, having noticed the success of Road to Serfdom, wanted to persuade Hayek to come to the USA. Hayek, in turn, persuaded the Volcker Fund to support a new study program called Free Market Study led by Director (who was at the Law department). When Hayek finally was offered a position at the university

104 Market as ideology it was on the university’s Committee for Social Thought (not the Economics department). Madrick (2011, p. 36) thinks it was because his radicalism would have threatened the established order at that department. As mentioned, Friedman directed his energies in research towards showing that Keynes was wrong in recommending deficit spending by the State in recession times. His line of attack was to update a theory on the effect of the money supply that had been taken up, again, and refined by Irving Fisher. (Note that this was a topic that the “Doctors of Salamanca” had discussed some 500 years earlier.) The theory held that the amount of goods and services produced was dependent upon the size of the money supply, and upon the velocity (rate of turnover) of money. Keynes was wrong because if a government were to finance its increased spending by borrowing it would “crowd out” valuable private borrowing and growth would stay the same (or be reduced). To prove his point, Friedman embarked on a very large project, with Anna Schwartz, to reconstruct the money supply data since the Civil War and relate them to the ups and downs of the GDP. In 1963 the results were published in A Monetary History of United States 1867–1960. There was, indeed, a relation between money supply and GDP changes, but the relation was too broad based to arrive at any policy conclusions (critiques thought), equally one could not be sure about the direction of the relation. The concept “endogeneity of money” refers to the idea that quantity of money is a creation of the strength of the economy. James Tobin, for one, also pointed out that it is unwise to rely on data from the 1930s and 1940s as “normal” and the 1920s and the 1950s as “abnormal” for measures of money velocity. The key factor in Keynes’ theory was the multiplier effect (that government spending, in turn, will generate more spending by its recipients, etc.). Friedman also gathered data to show that people do not spend as much as Keynes assumed. They decide, he claimed, on the basis of expected future income rather than on the basis of the one-off effect of current government spending. He managed to show that the multiplier effect was smaller than Keynes assumed (but it was still there), but in the process he exaggerated the ability of people to foresee their future income (critics claimed). The project established a new interest in monetary policies, which now became the main tool for combatting inflation. However, the instability of money velocity undid monetarism in the 1980s, even if the simple act of flushing the economy with money is still popular (and maintaining, as in Sweden, the interest rate below zero, causing the currency to depreciate, which promotes export (and jobs), which is good in election times). Arguably, Friedman’s most important theoretical contribution was his claim that there is a normal (later called “natural”) rate of unemployment, below which inflation will be stimulated. The argument is that as unemployment goes below the “natural level”, wages will go up and firms will have to compensate by raising prices. As government will try to stimulate the economy (Keynesianism) to push the unemployment level down again, prices will increase again, eliminating the purchasing power of the wage increases and unemployment will come back

Market as ideology 105 again to its “natural” level. Nowadays economists argue that the “natural” level shifts from time to time. Friedman was an activist, a gifted speaker and clear writer. In 1962 he published Capitalism and Freedom without gaining much attention. In 1964 he joined Barry Goldwater’s campaign for the presidency as economic advisor. In 1966 Newsweek offered him the opportunity to write his own column. He made television appearances. Almost all his proposals in Capitalism and Freedom were taken up in policy debates by his proponents. The Federal Reserve adopted his monetary policy in 1979 but abandoned it a few years later. Now his 1980 book with Rose Friedman (his wife, a devoted libertarian) will be reviewed briefly. Free to Choose – A Personal Statement Free to Choose – A Personal Statement (Milton and Rose Friedman 1980) is based on Capitalism and Freedom and a TV series of 10 programs with Friedman. It is decidedly “popular” in its presentation of arguments against an interventionist State, and for increased freedom of choice for individuals, as the solution to most social and economic problems. Having been alerted to Plato’s rhetorical methods by Popper we can see similar patterns in the Friedman approach. There is frequent reference to “origins”, i.e., going back to old historical sources to “prove” a point about current problems. Adam Smith is used very often as an authority on free trade and competition, as are the founding fathers’ formulations. There is nothing wrong with that, except that those authorities were dealing with current problems more than 200 years ago. The “facts” were different then, even if their phrases were (rhetorically) convincing. Further, the Friedmans often label things normal or “natural” when these are rather assumptions on their side that are required for their arguments to hold. This is a technique that is pre-modern (scholasticism) in that social philosophers and scientists in that era usually referred to introspection as a source of knowledge on human behaviour in their reasoning (like Adam Smith did – even if he recommended the “impartial spectator procedure” in moral reasoning).2 They also refer to “movements” among the people to dismantle crippling State bureaucracy. The ascent of Margaret Thatcher is promising, and the Swedish Welfare State is doomed now that the social democrats have been defeated in the election (although they did come back soon after). Single cases are typically used to show the meaning of more general statements – carefully selected cases – no doubt for pedagogical reasons. The book starts out in praising the strength of the market, where cooperation through voluntary exchange makes everybody better off, and how the price mechanism transfers information about the value of things to people who need it, i.e., to the insiders. This happens because those with the information have an interest to transfer the information to those who have use for it, and those who have use for the information want to gather that information. It is useful because people have an incentive to act on it. Action, i.e., voluntary

106 Market as ideology exchange, will have an effect on the income distribution, since both parties to an exchange consider themselves better off after the exchange since their sales income is greater than the production cost of the exchange object (and vice versa). Since both will be better off, there will be economic growth. The “invisible hand” metaphor is also widened to other areas of life where sophisticated structures emerge as unintended consequences of a large number of people cooperating while seeking their own benefit. Take language for example, or science, where spontaneous interaction leads to progress! Then “the State” is brought in. Adam Smith defined the duties of the State as (1) to protect citizens, (2) carry out careful justice, (3) promote voluntary exchange by introducing generally applicable rules. The third duty is the difficult one since we cannot allow unlimited expansion of State intervention. The Friedmans present examples of such limits to State expansion in practice. There follows a chapter on the tyranny of regulation and planning with arguments for free trade and private property rights. A third chapter describes the emergence of the federal reserve system, the crisis of 1929, and the failure of the FED to combat the crisis by increasing the volume of money in the economy, and, finally (December 1930) the closure of the Bank of United States (its name was thought to constitute unfair competition for immigrant deposits). A plan to save it by setting up a guarantee fund failed because New York Clearing House backed out in the last moment. The consequences were dire. In the same month 352 banks went bankrupt. Since banks had to call repayment of loans to pay their own debt, the economy stalled and the depression became a fact. The crisis generated space for a discourse on safety and welfare; the “New Deal” was established. The idea of the Welfare State, with extensive obligations for the State, gained adherents, but the results were frightening. In Britain unemployment grew and Margaret Thatcher came in as a saviour; Sweden has fared better than Britain but the people were fed up and replaced the social democratic government in 1976 (still we have not seen any real change of direction, the Friedmans claim). The most dramatic example in the USA is the failure of New York City. The city had invested unwisely in a large hospital, a university, and tuition free education – Federal money saved it. The welfare State does not work because it transfers money to the middle class (notably the bureaucrats), at the expense of the rich and the very poor. The chapter concludes with recipes on what to do to put a stop to the waste. A final chapter, on equality, argues that by putting emphasis on freedom we will get greater equality as a welcome by-product. Now the stage is set to discuss more in detail the reform requirements in different sectors of society. First schools; the problem there is that public schools have been bureaucratized and the solution is free choice based on a voucher system. The same is true of higher education. Consumer protection should be achieved by information rather than regulation. (Prohibition did not stop the consumption of alcohol!) If the government has information about the benefits of using safety belts in cars or avoiding cyclamates or DDT it should let us know. But we should decide for ourselves what risks we are willing to take with our own lives.

Market as ideology 107 Who protects labour? Labour unions, one would assume. The Friedmans claim that unions, which do not have that many members anyway, only redistribute resources to those who have jobs from those who have not. The power of unions comes, not so much from threats to damage the employers’ equipment, as from their ability to elicit help from the State, for instance concerning minimum wages, or to limit the number of workers, like in the medical profession where authorities set the criteria for legitimation to practice medicine. (Remember Friedman’s PhD thesis.) Look, say the Friedmans, the headquarters of the unions are gathered around Capitol Hill in Washington. Undue influence peddling is going on (special interests!). All these State interventions lead to waste, which contributes to inflation, the process whereby people are robbed of the purchasing power of their savings. Of course, they like the value increase of their houses and the lower value of the debt they have to repay, but soon the bank will compensate by increasing the interest rate and inflation will accelerate and spread. The cure for inflation is management of the volume of money in the economy. The consequences will be painful for a while, but the diagrams show that inflation moves in step with the volume of money. The consequences in terms of higher unemployment and slower growth are not the cure, they are the unfortunate side effects of the cure. The argument in this final descriptive chapter is full of illustrative anecdotes from many countries. The important conclusion is that inflation is a monetary problem. It is the government/State that decides about the money supply nowadays. (Should it be more efficient in doing this?) The final chapter indicates that the tide is turning, i.e., the collectivist solutions are giving way to individualism and freedom of choice. Margret Thatcher is one sign, Proposition 13 in California another. It is the intellectuals that are the main target of the Friedmans’ arguments. Once opinion has started to change and it reaches the general public there will be a quiet revolution. The Friedmans cite an article in the Wall Street Journal about “the Swedish tax revolt” to show how far we have come. The tide is turning, but special interest groups still sway power in Washington in their lobby relation with the bureaucrats of all these program-specific agencies. The smaller the State apparatus, the more limited the opportunities for special interests to lobby against the general public interest. The book ends with suggested changes of the constitution, which by the way, can be integrated into one package law stating that the right of the people to buy and sell legal goods and services at mutually satisfactory terms must not be infringed upon by Congress or any of the States. The free market will solve all and any problems. (Of course, one could discuss what goods and services should be considered legal.) The book by the Friedmans is openly political as indicated by the subtitle “A Personal Statement”. The rhetorical principles are the same as those pointed out as used by Plato in his frustration over the decay of Athens into a mire of democratic irresponsibility. Back to the origins and toward what is “natural” are the design principles the Friedmans apply. Many of the carefully chosen tales from the current debate as well as from far away countries, like the Meiji

108 Market as ideology restoration in Japan in the 1860s, give meaning to the arguments. However, being a Swede myself, and having experienced the “Swedish tax revolt”, I cannot help wondering why the change of government was not described as due to the victory of liberal ideas, but instead the result of a “tax revolt” by the Swedish people against the former government. Milton Friedman was the shining star in economics and a Nobel laureate (never mind that it was not a “real” Nobel prize), and this book illustrates how far the discipline of economics has come in its desire to design a State suitable to its theory, and in line with neo-liberal conceptions of society. It signals that human activity can be reduced to economics, we all strive towards utility. “The pursuit of happiness” clause of the Constitution can readily be translated into the pursuit of money since money is the instrument to use for whatever purpose the individual desires. Bureaucrats should not decide for us whether we should use safety belts. We must be allowed to decide for ourselves what risks we want to take. One can note a glimmer of a wish for the State to be effective in its actions (avoid waste) in the midst of all the arguments for freedom and market solutions – but it is just a glimmer. The neo-liberals promoted their case chiefly by remaining academics, while serving as advisors, e.g., to Barry Goldwater and to president Pinochet. The final step of theory development to set the stage for the financial crisis of 2008 was the appropriation of micro economics by Jensen & Meckling (1976) of Chicago, who shifted focus, from the entrepreneur/owner calculating costs and revenue for business in the spirit of the Austrian School of Economics in order to maximize profit, to the investor in equity seeking shareholder value by holding gains. While the businessman of old had to contemplate costs for logistics, investment in machinery, labour, material and more, to establish a cost curve to be compared to expected prices and volumes in product markets, the new theory of the firm saw an investor in equity or debt in an organization seen as a nexus of contracts where the value of it all was determined by “the market” consisting of other investors looking for opportunities to harvest value gains. The decision problem was one of expectations and risks concerning changes in market value of financial instruments rather than the old focus on quality and price of products. There remained, of course the age-old problem of the separation between ownership and control of large corporations, which Berle & Means (1932) had so eloquently demonstrated. By assuming that members of the organization were on contract (rules of the game written down) the agency problem (how do owners control the professional managers running the company?) could be translated into promoting an ever increasing value of the shares of the company. This could be done by monitoring financial results (rather than the operations themselves) and by designing incentives to be tied to share-holder value. Those owners who do not like what they see can just leave – the market will determine fair share prices. We call this shift of focus from the management of the firm to the investment and control by temporary/disloyal owners and lenders “financialization”. Financial instruments (promises to pay a certain amount if certain conditions are fulfilled) were now

Market as ideology 109 at the centre of attention, and the expected value changes of these instruments in financial markets had become the object of modelling and calculation. The stage was set for de-regulation to expand markets and the reach of investors. The study of “financialization” and its effects on society is a growing and interesting field engaging economists as well as jurists (Ireland 2009). There was a parallel development focused almost exclusively on reducing the influence of the State, and applying “Bolshevik” tactics to protect a certain minority from being abused by an irresponsible majority – all in the name of freedom – of course; the libertarians.

4:4 Libertarianism Libertarianism is a movement that has been particularly successful in the USA to promote “property rights” against the vagaries of majority democracy. Should groups bond together to further their “special interests” one cannot know where it will end. The largest danger is when the State is used as a tool for such interests, which can well happen since we know that the employees of the State from sheer self-interest will accommodate those special interests. The best defence against such assaults on property rights as progressive taxation, and the limiting of access to professions (or to guns), is to reduce the State to cater for police, courts, and military matters only. In Democracy in Chains (2017) – a book that aroused heated debate with the author being criticized for unfair treatment of James McGill Buchanan by biasing her selection of quotes3 – Nancy MacLean traces the development of libertarian ideas to their origins in Virginian resistance to anti-slavery legislation in the 19th century. It was planters/slave owners who resented the infringement on their “property rights”, which the democratic institutions in Washington had initiated. Democracy (tyranny of the majority) was pitted against property rights and the mission was to save the minority’s privileged position from interference from Washington. First the strategy was to further the states’ right to “interpose” state government veto against the federal “collectivism”. The most outspoken defender of property rights in those early days was John Calhoun, a “cast iron man” according to an acquaintance. One of his arguments was that the authority of the Constitution comes, not from the American people, but from the state governments. It was the signatures of the states that made USA united. Therefore, the state governments have the right to “interpose” their judgement of the appropriateness of laws made in Washington for their particular circumstances. “Property rights” and “state rights” came to be used as synonyms. Since Virginians realized that they could not gain majority in Congress for their specific mission, the solution was to promote “states’ rights” in general and interpret the Constitution to their advantage.4 The most offensive legislation according to the Virginians was the order to stop discrimination in public schools on the basis of race. Their response was a systematic privatization of schools and the use of a variety of legalistic tricks to stop the inferior races from participation in elections. This was common in

110 Market as ideology most Southern states and was possible because the elite could control the state government. The most infamous result of these endeavours to control democracy was the Byrd Organization (“united establishment of Virginia”) – not at all like the party machines in the north that doled out benefits to almost anybody – built by the Governor (for most of the 1920s), and later Senator (1933– 1965), Harry Flood Byrd Sr., who held power by controlling only 10% of the electorate for 40 years. When court orders to integrate schools became too difficult to withstand – one such resistance strategy was to close down any public school that accepted integration – activists were invited to Washington to strategize with Senator Byrd. It is against this kind of background that James M. Buchanan established himself as a theorist of liberty, MacLean claims. Buchanan was a rising star since his appointment as professor and head of the economics department at the University of Virginia. Its president, Colgate Whitehead Darden Jr, got a letter from this new department head in late 1956 with a proposal to set up a new School of Political Economy and Social Philosophy at the university. Its purpose was to combat the “perverted liberalism” that would use the state to impose regulations on the people (like integrating schools), and argue instead, for a foundation in “individual liberty”. What the president (of the university) needed to do was to find the funding for such a School. Buchanan had enrolled for doctoral studies at Chicago in 1946, and was soon turned into a zealot advocate for “the market order” inspired by the leader of the Chicago School at the time, professor Frank Knight. The following year, 1947, Frank Knight and some other faculty members travelled to Switzerland to a meeting in Mont Pélerin at the invitation of Friedrich Hayek. There were a little more than 30 participants, mostly academics, who were determined to do what they could to prevent another rise of absolutist government (communist or fascist) in the Western world. Hayek had just got his book Road to Serfdom published in the USA (shortened) by Reader’s Digest. That book was a success, and its message was that we should return to “the abandoned road” of classical liberalism. There simply is no better mechanism for coordinating the desires of free individuals than the price signals of supply and demand into a “spontaneous order”. The funding for the trip to Europe by Frank Knight and his colleagues came from the William Volcker Fund, which also paid for Hayek’s subsequent tour of the USA and subsidized his salary at the University of Chicago. Furthermore, the Volcker Fund also financed Aaron Director at Chicago, and Ludwig von Mises at New York University. The outcome of the ten-day Mont Pélerin meeting was the Mont Pélerin Society (MPS; membership by invitation only), a network of intellectuals aiming to further peace and prosperity by freeing markets, with annual meetings up to this day.5 Buchanan, to avoid direct competition with his colleague, Milton Friedman, chose to orient his interest to public finance. Scholars at the time tended to focus on “market failures” that required government intervention to save companies or industries. Buchanan chose “government failure”. He realised how important

Market as ideology 111 trust was for political power, and the growth of the public sector. Inspired by, amongst others, Knut Wicksell he assumed that theory must abandon the traditional view of politicians as “benevolent despots” and start to scrutinise, critically, the rules, practices and incentives at work in “politics without romance”. The problem Buchanan wanted to address with his (1956) proposal for a Thomas Jefferson Centre for Political Economy and Social Philosophy was to combat the disturbing tendency toward “equalitarianism”, social engineering, and efforts by the State to change the way people thought about government. The collectivist ideology (the Keynesian idea that the government could do something to start recoveries in economic crises by overspending) already had a grip on the minds of intellectuals. Buchanan (1982, pp. 6–9) stated later that “our purpose was indeed subversive”. The funding for the new centre was successful and Buchanan engaged intensely in recruiting young idealists to the cause. Hayek was invited and was so impressed with the work for property rights that he issued an invitation on the spot for both Buchanan and his close co-worker Warren Nutter to join the Mont Pélerin Society. Early on, the Centre attacked the unions as collectivist (special interests) and for receiving unwarranted support from central government. But soon, focus shifted to the problem of public schools. Several schools had announced their intention to admit a number of black pupils. The Governor responded by threatening to close schools that went through with this. Harry Byrd was challenged for his senate seat at the time, but won. Buchanan and Nutter had a different view of the school problem; they claimed that “State-run schools had effective monopoly”, private schools on the other hand had to compete for students and were therefore likely to come up with a variety of study programs for parents to choose from. This was not racist. The purpose was to promote improvement. To set the shift toward market-based solutions for schools in motion Virginia should provide a tax-subsidy voucher system for free schools. This was in line with Milton Friedman’s solution of the 1950s. Next, the success in using legislation to eliminate a large number of impediments to the participation of all in elections, during the 1960–1970s, became a top priority. This was understood by Buchanan and associates as a threat to market freedom, i.e., as majority abuse of the minority – the entrepreneurs. Although Buchanan, and his co-author, Gordon Tullock – with a doctorate in Law – did not get along too well, they produced a book arguing the case for market freedom in The Calculus of Consent. Both had a deep-felt belief that the best way to protect the freedom of markets was to expose the “foibles” of government (MacLean 2017, p. 77). The message of this book is that politicians must be understood as rational beings, who serve their own interest (which is re-election). By studying any country’s constitution, we can identify incentives, as well as constraints, that shape their behaviour. Since politicians allocate, not their own funds, but the taxpayers’, they will invite “special interests” in collective pursuit of profit (rent-seeking) from governmental programs. Candidates win elections by making promises to these “special interests”. To make matters worse they make promises to multiple groups, and while in office they make

112 Market as ideology deals with other politicians (if you support my proposal I will support yours – called “log-rolling”). This results in overinvestment in the public sector. MacLean (2017, p. 79) claims that here is the “germ of today’s billionaires bid to shackle democracy”. This “public choice” behaviour tends to violate the liberty of the minority. The only fair decision model, to “confine the (political) exploitation of man by man within acceptable limits” is decision by unanimity (This has been tried: in Sweden we call it “Polish Parliament”!). The Calculus of Consent was well received in many quarters. While Buchanan concentrated on the theoretical core of this area of study (constitutional regulation of property rights), Tullock saw the long-term effects on propaganda by way of students. (A “trickle down” effect?) In 1964 Barry Goldwater lost the presidential election. His campaign, advised by Milton Friedman and Buchanan’s colleague Warren Nutter, was built on the capitalism versus socialism theme and Goldwater argued in his acceptance speech for the nomination that “Extremism in defence of liberty is no vice!” Friedman still maintained in his old age that the speech was brilliant, even if Goldwater did not win very many votes. MacLean (2017, p. 92) maintains that the public exposure of the Goldwater campaign helped Friedman in his career considerably, with Newsweek inviting him to write a column. Now Buchanan engaged in an academic fight to get his recent co-author promoted to full professorship in economics. Tullock had never taken a course in economics. His effort failed, and true to his threat in the process, Buchanan left University of Virginia (UVA) for UCLA. When Professor Nutter also left, to join President Nixon’s staff, the Virginia institute declined. At UCLA, Buchanan encountered student unrest and wrote an economic diagnosis of the situation in Academia in Anarchy with Niclos Devletoglou in 1970. In this book, the “theory” is that, 1) those who consume the product (the students) do not pay for it (not fully), 2) those who produce it do not sell it (the faculty), and 3) those who finance it do not control it (the tax payers). There is plenty of room for “special interests” there! However, not feeling enough appreciated Buchanan soon left UCLA to return to the South (Virginia Polytechnic Institute, then considered a second-rate university, which had recently become a research university) to implement a new proposed Centre for the Study of Public Choice. It was here that Charles Koch, arguably the central figure of the libertarian movement, saw the potential in his ideas. Fred Koch had four sons, and earned his living in the oil-refinery business, Charles watched his father fight a large competitor, Universal Oil, through courts, and lose. Universal Oil claimed that Fred Koch had violated a patent, Fred denied this. Universal Oil habitually used this strategy in the courts to subdue competitors. An investigative reporter later informed Fred Koch that bribery was involved. It took 20 years of legal struggle before the corruption was exposed and Koch could win his case. This experience of “rent-seeking” civil servants would colour Charles Koch’s view of the public sector. His father

Market as ideology 113 was a “John Wayne-type” of a person that believed in “hardening” his sons (and in the John Birch Society). He was a radical Republican conservative. Charles Koch studied successfully at MIT (three engineering degrees) and did some consulting, but returned to Koch Industries when his father fell ill, to run the company (from 1967). The Koch family soon was among the wealthiest in the USA. MacLean (2017, p. 130) notes that Charles was respected for his abilities to “play the long game” – long term strategy – which other American industries were just beginning to understand. Buchanan was upset by the disrespectful behaviour of students, also at Virginia Polytech, and gave the advice to its president, Hahn, to strike it down with harsh measures. (Hahn did not follow the advice.) Buchanan could raise funds for a new centre in this context: “Our research will change the way people think about the way the government works” is a key line in one of his applications for funds. The new initiatives at the Virginia school caught attention. Buchanan was invited to talk at the Mont Pélerin Society meeting in Munich. He argued that modern society with its widespread affluence had become “willing to allow for the existence of parasites” – the solution was simple, “close off the parasitic option” (MacLean 2017, p. 117). In September of 1973 Buchanan gave the opening address at the inaugural banquet for the founders of the International Atlantic Economic Society. The “Watergate mess” was a setback for the political right and Nixon could not deliver on his promises of budget cuts; a new strategy was required. Buchanan had discussed his theses with trusted colleagues and supporters earlier, but this was the first time he went public. What was required was an effective “counter intelligentsia”. The problem was that the liberal intellectuals dominated the media and thereby the “elected political leaders”. Now was the time to pull together the like-minded and “indoctrinate” them with compelling arguments and allocate them in a strategic manner. This new “vast network of political power will be the Establishment” – “conspirational secrecy is at all times essential” (MacLean 2017, p. 117). The old argument about “States’ rights” had lost its power. The American Leviathan was on a rampage, using taxpayers’ money to “support unproductive and essentially parasitic members of society”. The new strategy needed to change the way people think about government – “Large things start from small beginnings”. Soon after this address Buchanan organized a similar gathering in California where some of Reagan’s men (then Governor), notably Edwin Meese, participated. A first target, it was agreed, was to counter the “subversion in our law schools”. The California-based Institute of Contemporary Studies (future Supreme Court Justice Anthony Kennedy was one of the recruits) was set up, and the Law and Economics Center (run by Law and Economics professor Henry Manne) at the University of Miami. A sympathiser, future Supreme Court Justice Lewis Powell, wrote the report for the Virginia Commission on Constitutional Government, which argued forcefully for business to mobilize against the attacks on the enterprise system, the most important instrument being the courts.

114 Market as ideology Charles Koch, a member of the Mont Pélerin Society since 1970, had learnt from Ludwig von Mises that entrepreneurs are the soul of a good society, and from Schumpeter that the “creative destruction” of an effective market sorts out the bad apples and lets the well-managed firms harvest the fruits of their efforts. Government, on the other hand, is through and through infested by “rent-seeking” special interests. This is why Charles Koch bypassed Milton Friedman and joined forces with James Buchanan. Milton Friedman, and his fellow neo-liberals, wanted to make government work more effectively, which was contrary to a true libertarian credo. Now Koch started to invest in intellectual centres to promote the cause of liberty. It was at the Institute for Humane Studies, set up to promote the Austrian Economics favoured by Koch, that he met Buchanan properly to discuss strategy. Buchanan saw the utility of assuming the role of “the American Hayek”. There were other actors in the race toward think tanks, like Murray Rothbard (who advised Koch to study Lenin on Bolshevik strategy and tactics to “take over” a revolution), William Simon (of the Olin Foundation) and Edward Crane (who came to lead the cadre training institute that was named the Cato Institute after the Roman senator Cato who repeatedly argued that “Chartage must be destroyed” – but also, advised landowners to sell aging slaves before they became useless, and to be strict with them when inspecting estates). The same year (1975) as the Cato Institute was founded Buchanan published a chapter, “The Samaritan’s Dilemma”, in a book edited by Phelps, Altruism, Morality and Economic Theory, where he argued that we can be too compassionate for our own well-being, using a game theory thought experiment to prove his point. He also published Limits to Liberty: Between Anarchy and Leviathan (1975), where he argued that there are not really any effective limits to the taxation of minorities, and pointed to a deficiency in the constitutional order. But despotism, a private governing elite, was an alternative Buchan disliked as well, and Murray was troubled by too. This issue was brought up on the agenda for the Mont Pélerin Society meeting in 1978 by Stigler, the current president of the society. Buchanan’s solution was to re-design the constitution to prevent the majority from overtaxing the minority. An opportunity for a test run of the constitutional approach offered itself with Pinochet’s coup d’état in Chile in September 1973. Mont Pélerin Society representatives visited Chile to be informed and to advise; Milton Friedman on how to combat the soaring inflation (disastrous results), Hayek just seemed to have talked with Pinochet about his distaste for “unlimited democracy” (MacLean 2017, p. 155), while Buchanan’s visit yielded more long-lasting results. Buchanan worked with Labour Minister José Pinera to design structural reforms, like privatizing huge pension funds (Pinera later came to the Cato Institute to promote the privatization of US Social Security). When Buchanan visited for a week the regime had just carried out a mass purge of unreliable university teachers. His advice concerned the details of a constitution that would bind democracy by over-representing the conservative minority. Buchanan did not reveal his feelings about advising a dictatorship on a more

Market as ideology 115 effective constitution, but he must have regretted the “socialization” of the losses to save the now unregulated banks in Chile that failed in the wake of reckless lending (MacLean 2017, p. 164). Back from Chile, Buchanan met opposition from an economics colleague (Daniel Orr) at the Virginia Tech about Buchanan’s courses being too onesidedly non-mathematical for graduates to have a chance of an academic career. Having failed to get his opponent fired Buchanan let it be known to people at the Economics department of Georg Mason University (“a spectacularly undistinguished school” according to MacLean 2017, p. 171) that he was interested in moving there with his team. Koch and related donators provided ample funds, and a new orientation, toward the policy centres in neighbouring Washington was initiated – GMU was later described as “The Pentagon of conservative academia” by the Wall Street Journal (1988). The Mont Pélerin Society rejoiced in the election victories of Reagan and Thatcher, hoping that now they would deliver on their promises. In the USA, Reagan’s budget director, David Stockman, was the “field general” for libertarians (MacLean 2017, p. 175). His proposal concerning massive tax cuts – known as the Kemp-Roth proposal – would also have meant massive cuts in social welfare, but it failed to attract a majority in congress. “Democracy had defeated the doctrine”. This experience, according to MacLean (2017, 176f.), became a turning point in the Republican Party. There was a split, represented by (lonely) Stockman, Republican conservatives, and the libertarians. The libertarians of the Virginia school concluded that to achieve their ends they had to “stop being honest with the public” (MacLean 2017, p. 177). The first step must be to soften the public support for the system by making it seem unreliable. The second step would be to divide and conquer (splitting recipients). Those who were already on Social Security would be assured that their benefits would not be cut. For those who earned a decent salary the argument would be that they paid a higher tax than others for their benefits, a third group was the young who should be constantly reminded that they pay a “tremendous” subsidy to the aged, and a fourth group who just missed the cut off for the old system should be reminded of the need for short-term changes. (This targeting of different groups with different arguments is a tactic that we recognize!) A “Leninist” strategy was recommended by the Heritage Foundation to forge a winning coalition to break the bond between the public and the government. In 1986 Buchanan was awarded the “economics Nobel Prize” for his public choice theory and his emphasis on “the significance of fundamental rules”. By now Charles Koch had moved his Californian Institute for Humane Studies to the George Mason University. Frustrated with the lack of progress for the cause (being “outwitted” by Clinton) Koch asked Buchanan for an operational strategy, which comprised two components; a) the small steps had to be well connected (backward and forward), and b) it would be necessary to present the intended reforms as efforts to shore up the welfare systems (Medicare and Social Security), when they in fact were intended to be dismantled. Koch made a speech to encourage the Buchanan cadre when he handed over a 10 million

116 Market as ideology USD grant for research in 1997. Now Koch also sent in his own people (notably Richie Fink). In fund-raising letters, the new staff stressed their influence in Washington and in courts. Buchanan was upset by his good name being exploited. He was no longer in charge of the institute bearing his name. Even if he was awarded the George Mason Medal (together with Charles Koch) he realized that his academic credentials had been compromised and his days as an academic were over. He stopped coming to campus from 1998, and retired in 2008. He died in 2013. In her conclusion MacLean (2017, pp. 277 ff.) argues that the Koch operatives had hijacked the Buchanan Centre and pushed the theoretical core to the side for political activism. Tyler Cowen, Buchanan’s successor as director of the Buchanan Centre, is quoted as saying “we will cut Medicaid for the poor” (Cowen 2013). The need for theory was now declining. In following the MacLean (2017) book for an account of how libertarianism grew to become a political force in the USA and elsewhere, one can clearly notice that there is selectivity in the facts that are used. Friends and co-workers to Buchanan that I have talked to are upset about how he is treated by MacLean. He was not at all like she portrays him. I am sure that he was not, but his texts can be used for political purposes. It is true, also, that he was not so much into measurement and strict analysis to test his claims. Therefore, he was a useful target to be “hijacked” by the neo-conservative movement with Charles Koch at the vanguard. There are good reasons to contemplate what responsibility scholars have when their theoretical achievements are used for political purposes, and even are distorted to achieve goals that the scholar cannot agree with. This is one side of coin; the other is that we must be aware of when scholars turn into political activists in order to provide advice on policies for governments to implement. There are good instrumental reasons to do so, if we keep to the instrumental dimensions of policy – what would be the likely outcome of this or that design of a social security reform given the knowledge we have about the current population? But it is harder to draw the line when it comes to advice as to what goals the government should strive for. On one side the government is likely to make a well-informed decision if scholars also participate in the debate over advantages and disadvantages of different aspects of a pending reform. But scholars must also be aware of possible abuse of their results. They need to try to prevent/defuse such abuse by speaking up against such tendencies. The issue under debate at the time of writing (2017), about Cambridge Analytica, a consultancy firm that collected personal information on individuals and sold “profiled” compilations to organizations willing to pay (to use in election (or sales) campaigns) is a greater issue than we can see now. We are at best only at the beginning of a process toward a more honest democracy, hopefully. Reports from Russia of today (Clover 2016) show that the same methods are used by the State there. “Big data”, modelling theory, and huge computer capacity make abuse possible. Akerlof & Shiller (2015) claim, in their

Market as ideology 117 “Phishing for Phools”, that if rules of conduct can be broken for private gain they are likely to be broken. The academic tradition, in analysing complex situations using game theory, has been based on the assumption that the game is defined by the rules and a precondition for the analysis is that game participants follow the rules. When similar assumptions about the efficiency of markets are “reified” to the extent that regulators prescribe that business life must follow given rules derived from academic research under idealized conditions, we are on a “slippery slope”. To argue for a dismantling of all State intervention in the name of freedom and hope for the “market” to solve all problems, is irresponsible when the argument comes from scholars that do their work inside idealized, model worlds. Still, it is a fact, which these accounts of scholarly comments and debates among scholars and “Consultant Administrators and Pamphleteers” (to use Schumpeter’s (1954) words) have shown, that men of knowledge have always tried to interfere with current practices in the name of progress. The new dimension that is clear in the post-war period is that the “pamphleteers” have organized themselves into activist societies (“epistemic communities”). This increases their power to influence, and they have been quite successful in their mission, both in the public sector itself (“New Public Management”, see Hood & Dixon 2015), and in de-regulation of financial markets. The problem, I believe, is that de-regulation opens up vast vistas of benefits from rulebreaking that we have little research knowledge of (for obvious reasons). Visits and short interviews with people who work in banks’ (growing) security departments, protecting the bank and its customers against fraud, seem to show that those departments have one working hypothesis; the other side is intelligent, creative and malevolent – if we have managed to stop one attempt they will soon come up with something else. No game theory there! More likely, trial-and-error! Perhaps the organizing of “epistemic communities” is driven by a legitimate desire to make the world be better aligned with theory? This is called “reification” in some circles. As noted above, Haas (1992, p. 3) defines an epistemic community as a network of professionals with recognized expertise and competence in a particular domain and an authoritative claim to policy-relevant knowledge within that domain or issue-area. Both movements, neo-liberal and libertarian, build authority on academic achievement; neo-liberalism was first to appear as a unit giving policy advice to governments, libertarians focus on training zealots for service in strategic parts of the administration. Even if neo-liberals promoted freedom, free trade and market solutions, they have been careful to avoid getting involved in party politics. Libertarianism, on the other hand, although stemming from the same theory base (Austrian economics) has been more articulate in wanting to reduce State bureaucracy, and taxes. Libertarians have engaged in party politics and their tactics have shifted toward winning power (if necessary, by taking over a revolution already in progress – like the Bolsheviks did). Also, there has been an emphasis in the last few decades on training young people (true believers)

118 Market as ideology for a career in government. The academic credibility of the libertarian movement must be judged to have deteriorated with the retirement of Professor Buchanan. Both movements favoured de-regulation as carried out by Thatcher and Reagan. To illustrate what effects de-regulation may have on the management of individual banks – beside the unfortunate fate of Barings in 1997 faced with an overflow of strategic options, little capital, and lacking management capacity to carry required acquisitions out (I called it strategic stress syndrome) – here is another case of a bank that travelled from obscurity to spectacular bust, the Royal Bank of Scotland.

4:5 Failed banks under de-regulation 4:5:1 Case 5. The rise and decline of Royal Bank of Scotland I have chosen Fraser’s book (2014) on the troubles of the Royal Bank of Scotland (RBS) to illustrate how the practice of banking can go from good to bad in a very short time if conditions are conducive to such a development. I could have chosen several other accounts in the flow of reports about individual banks caught in the maelstrom of the recent financial crisis (Grind 2012) on Washington Mutual, Carswell, (2011) on the Anglo-Irish bank, Neurath (2012) on Swedish HQ bank, Perman (2013) on the HBOS and so on) – the patterns are quite similar. I am fully aware of the fact that those books were often written by business journalists specializing in banks, and not scientific researchers. These authors wanted to tell a story, preferably from the “inside” of these banks, and this is what I am after – the story about what happened, and who was involved, when a previously good and highly valued bank failed. The objection that these authors do not declare what theory they apply is to be considered an advantage, and, finally, even if they are not trained researchers, they are definitely trained journalists, which is advantageous in getting a story right. A description of facts “on the ground” (which can be checked) and the use of common sense, rather than a particular theory to be tested, comes close to applying the Wittgenstein (1953) idea of phenomena “showing” themselves. As pointed out repeatedly in the chapters above there is reason to discuss the role of ideology in social sciences and such reasons will, I hope, be “shown” repeatedly in this and the other cases. A further case – that of the Icelandic banks, will follow directly after the case of RBS to provide variety. Here I do not know of any book written about the events yet; however, we have a proper governmental commission reporting (Report of the Special Investigation Commission (SIC), Althingi Iceland 2010), and legal proceedings against a number of managers in those banks going on as this is written. Furthermore, I have friends in Iceland who have helped me find material. The Financial Times (20 September, 2018) reports that 47 bankers have been prosecuted and sentenced for crimes after the recent financial crisis worldwide; 25 of them in Iceland – 11 in Spain, 1 in the USA, and in the UK,

Market as ideology 119 none. But first let us look at the spectacular success of the Royal Bank of Scotland (RBS). Inside RBS I have read Fraser’s book carefully, noting arguments and facts that seem strange in the light of received wisdom in finance/banking theories, I have then pieced together the shortest possible account of the rise and fall of the RBS (the reader asking for details should consult the book and all its notes and references). Actually, the title of that book (Shredded: Inside RBS) is rather clever, since the leader of the bank, during the most dramatic period, was Fred Goodwin, nicknamed “Fred the Shred”. This is what happened according to Fraser (2014). When he reported on banking and RBS (from 1999 to 2008) its most striking feature was its market value, that at times seemed detached from reality, he says. The value was greater than all other listed companies in Scotland put together. How could that happen? RBS originated in the Company of Scotland that tried to establish a colony in Panama. A Scottish colony in Panama was intended to participate in the general exploration and exploitation of resources in the colonies, but this project did not go too well. As part of the agreement to form the Union with Scotland in 1707 the British government paid compensation to those who lost money in Panama, and these resources were pooled to start “the Equivalent Company” that, in turn, was instrumental in starting the RBS in 1727. The earliest goal of the “new bank”, Fraser claims, was to put the “Old Bank” (Bank of Scotland) out of business. One can easily imagine fierce competition between the two rivals in Edinburgh – Bank of Scotland and Royal Bank of Scotland – in a relatively limited home market. After the First World War RBS found Scotland too small and embarked on the acquisition of four British banks (expansion by acquisition). The period after the Second World War was good to banks. Keynesian spending to rebuild society and strict regulation of the financial sector reduced risk. It also prevented new players from getting a foothold. When the heavy industries, like shipyards, declined, the RBS attempted, again, to solve problems by acquisition. The National Commercial Bank of Scotland, a larger bank than RBS, was acquired in 1969/70, resulting in a market share of some 40% and 700 branches. But it was banking volume rather than the promotion of growth of the Scottish economy that justified the acquisition. Management saw no merit in supporting the manufacturing sector. In 1981 the board accepted a take-over bid by the Standard Chartered Bank, but there was opposition from the public, and a competing offer from the Hongkong and Shanghai Banking Corporation (HSBC). The public was unaware of the fact that Lloyds Bank also had been pursuing a take-over of RBS for some time (and other banks, including Deutsche Bank, were thinking in similar terms). These threats supplied the argument for the board’s acceptance

120 Market as ideology of the Standard Chartered’s offer – it was a matter of defence against Lloyds. At this time the RBS was truly “in play”, as the term was, for being a target for take-over bids. The bank did not like that. The battle over Standard Chartered’s take-over bid generated an intense debate. The Thatcher government (despite its free market ideology) referred both offers to the Monopolies and Merger Commission, which concluded that neither of the bidders (Standard Chartered and HSBC) could be allowed to take over RBS. Thatcher had come to power in the election of 1979 on a program to reform the economy and “bring harmony” in by monetarism, lower taxes, and privatization. However, she included high interest rates in her policy and this generated decline in industrial investment and unemployment. Demands for her resignation emerged, but popularity returned with the victory in the Falklands war with Argentina, and Thatcher could embark on further free market reforms under the banner of “responsible capitalism”. RBS acted upon these reforms by acquisitions and by starting an insurance business (Direct Line). At this stage RBS was underperforming due to an unwieldy structure and multiplicity of businesses without matching systems of management. Mathewson recruited in 1987 Thatcher was re-elected for a third term, the shock therapy of reforms seemed to have worked, the economy was growing, share prices soared. In 1987 a fairly young (47 years) scientist (mathematics and physics, PhD in engineering), George Mathewson, was appointed director of RBS responsible for strategy and development. Even if he was not a banker, he had business experience from venture capital and had worked very actively with SDA (Scottish Development Agency) since 1981, recruiting “sunrise industries” to Silicon Glen, Scotland’s technology corridor. He was a close ally with the secretary of state for Scotland, George Younger, and represented “the future”. After announcing his resignation from SDA in March he was offered many jobs but chose RBS as a good opportunity. The current CEO,who had started his career in RBS at 16, and soon would retire, supported Mathewson, and saw him as a possible successor. But Mathewson had to prove himself first. He started his new job on 1 October, and on 17 October, “Black Monday”, the stock markets in New York and London crashed. Mathewson hardly noticed since he was busy familiarizing himself with the bank. “The Royal’s new strongman” (a headline at the time) saw his mission as “to shake things up”. The strategy for this, worked out in secret meetings with a small team, stressed marketing (properly targeted), besides layoffs, and the introduction of performance measures like “products per customer” (properly incentivized). These changes amounted to a cultural revolution. The current CEO, Winter, who had accepted the plan (called “Nova Reda”), was disturbed by the whirlwind implementation activities, and resigned “a broken man”. However, it seems like the new culture did not filter down through the ranks as Mathewson had expected.

Market as ideology 121 Britain’s “Big Bang” ended in a spectacular bust as property values declined by about 30% from 1990 to 1993 with attending bad debts. Mathewson initiated a further restructuring plan to improve management capacity and slim the structure further. This project, called Columbus, (he also did not know where he was going, internal comments went), included segmentation and specialization of staff, with the regional level dismantled. McKinsey was brought in to assist. Banking had changed from service to sales and profit, Mathewson argued that RBS should be best in class. No more “sleepwalkers” in the management team! Six hundred secretaries were made redundant. Managers had to type their own letters. One manager, quoted by Fraser (2014, p. 30), pointed out that “this meant that there was no longer any record of what we were doing”. Bad debts were transferred to a special unit “Specialized Lending Services”. Mathewson himself considered the Columbus project a success; the cost-to-income ratio came down from 65–70 to below 50. This success in using the bank’s resources more effectively came as a result of his marketing strategy, which was built on the idea of multi-branding. This included winning customers from the lazy big four banks by making deals with, e.g., Tesco to offer bank services in supermarkets under the brand Tesco Personal Finance, or to develop direct services in car insurance (Direct Line). This provided growth, profit and a comfortable cash flow that allowed Columbus and further similar ventures to mobilize further funds by increasing the bank’s ability to leverage capital. The next project area was financial engineering. RBS was now big but was considered a “plain vanilla bank” by corporate customers. It could not deliver the financial services that more “sophisticated” customers needed. So, Mathewson hired Iain Robertson (his own successor at the Scottish Development Agency) to lead a new corporate banking division, headquartered in London, which was assembled from existing business units. Still oriented toward competitive advantage in special niches this division sold products like “asset management” and other investor services. For example, it engaged in train and rolling-stock leasing, and in helping Enron with 14 structured finance deals – very profitable, initially, but with a huge loss as Enron went bankrupt in 2001. The globalization of RBS took two roads; into the USA via the acquisition of Citizens, in 1988, and a further 19 banks over the next 12 years, all absorbed into Graboys’ (and his successor Fish’s) Citizens. These CEOs of Citizens were allowed to run the American business as they saw fit with little interference from headquarters. And, the second, European road was fired on by the prospects of a single European market from 1992. This venture started with a strategic alliance with Spanish Santander (in 1988). Both moves were strongly criticised by bank analysts, who noted the declining profitability from 1988–1992. The 1990s constituted a disappointing decade for ambitious Mathewson, with a number of failed acquisitions. De-regulation had made it possible for building societies to de-mutualize and enter into mergers. RBS courted a number of them but failed to offer top prices. Mathewson did not want to enter into open price bidding for fear that a failed offer would make RBS itself a possible target for take-over bids. He preferred discrete negotiations with top

122 Market as ideology management in targeted banks to arrive at an acceptable solution, and then go public. A deal with Birmingham Midshires building society went to a public stage, but its members refused the RBS offer and chose a higher one. The plan had been to continue to run Birmingham Midshires as a separate brand (a policy that was to continue in later deals – remember multi-branding). Now RBS had caught the attention of competitors and had, indeed, become an interesting target! In late 1998 Martin Taylor, CEO of Barclays, suddenly resigned in a strategy dispute with his board. Barclays warned that profits for that year would be lower than expected. Now Barclays also was “in play”. The investment advisor, Terry Eccles of J.P. Morgan, “and probably egged on by the new recruit, Fred Goodwin” (Fraser 2014, p. 55) persuaded Mathewson to make a strategic offer for Barclays, a “reverse takeover” (i.e. the smaller partner takes over the larger one), but, with a new CEO appointed at Barclays, this deal was turned down as well. Mathewson had met Fred Goodwin in CSCB (Committee of the Scottish Clearing Bankers) meetings and was impressed by his “intellect, grasp of detail and no-nonsense approach” (Fraser 2014, p. 62). He asked Goodwin whether he would accept the job as finance director of RBS (indicating that a further step to CEO would be in sight). After some negotiation Goodwin had started at RBS in August 1998. It should be noted that after only 15 months at his previous job as CEO of the Clydesdale Bank Goodwin was deeply disliked at that bank for his autocratic style. Several of the management team had left. Goodwin had studied law but was chartered as accountant at Touche Ross (later Deloitte) where his greatest achievement according to his own opinion was “leading the worldwide liquidation of Bank of Credit and Commerce International (BCCI)”. In fact, Fraser reports, he was a junior member of a team, charged with back office chores. A colleague from that time said: “Either you were a solvency partner or you were not. Fred was not.” Still, in 2012 newspapers wrote that Goodwin had single-handedly led that liquidation. Commenting on his “autocratic style” at Clydesdale, Goodwin claimed he wanted to be judged on his results. A control freak and micro manager, Goodwin was obsessed with décor, appearance and tidiness (Fraser 2014, p. 69). However, when he was touring RBS to get acquainted with the organization, people were surprised by his lack of interest in credit scoring or anything that had to do with his role as finance director. On his new job, Goodwin soon developed a habit of “tearing people apart” at morning meetings. He was called “Fred the Shred” and some called the meetings (every day at 9:30 to 10:00) “morning beatings”. Bagging NatWest The most significant event in the rise of RBS was the hostile take-over of NatWest. That bank had itself been formed in a merger between Westminster Bank and National Provincial Bank in 1970. The NatWest affair was dramatic

Market as ideology 123 and drawn out. From 1999 NatWest had been in trouble. It had opened itself to “be in play” by announcing plans to buy the fund management group Legal & General Investors, but this deal met with resistance. Now Bank of Scotland (“The old bank”) saw an opportunity, and announced a hostile take-over bid in September 1999. RBS prepared a counter offer. Preferring a friendly merger RBS initiated negotiations with NatWest, but those negotiations turned sour because NatWest wanted to be the dominating part. The later hostile bid from RBS was well prepared by top-down as well as bottom-up analyses. Bidding ensued and RBS came out as victor after many turns (Fraser, chapter 9). Due to the good preparations, the merger went smoothly and was declared a success, (to be used as an argument by Goodwin in the coming years – a Harvard Business School case study was made under the title “Royal Bank of Scotland: Masters of Integration”). Two aspects of the integration of NatWest should be noted; due to internal conflicts and lack of organization there, RBS decided to get rid of many managers in the NatWest London office, but to let its American part continue relatively intact as Greenwich Capital; the other notable observation is that RBS decided to keep its “spread sheet approach” to group financial reporting, which meant that there was no “audit trail” to the underlying financial and operational information. NatWest turned out to have a more modern (integrated) system, but the proposal to install this also in RBS was turned down. This made RBS accounting more susceptible to cheating with the numbers. Soon after the NatWest deal was settled, Mathewson moved up to chair the board and Goodwin was given a free hand as CEO. RBS showed very good results for 2000, but the auditors refused to sign off on an issue related to the NatWest acquisition and Goodwin dismissed the auditors, PwC, and hired Deloitte instead. The new auditors were Goodwin’s former employers, and they got the contract without tender. Tensions soon developed between Mathewson and Goodwin resulting in Mathewson’s withdrawal from active participation. Increasingly, Mathewson participated in board meetings via the video conferencing facility installed in his home. Goodwin pursued growth, especially in the investment bank, but also through continued acquisitions of other banks in northeast USA on behalf of Citizen Financial. All the time Goodwin used the RBS retail bank as a cash cow, while increasing leverage. Goodwin wanted RBS to be one of the largest banks in the world, like Citigroup, and often talked about such rankings. He stressed the use of “metrics”, not least return on equity (RoE), in managing the bank. Discipline and punish Fraser (2014, Chapter 12) claims that a culture of fear emerged as a result of people who wanted to be open and honest about a situation risked being “shredded” in one of Goodwin’s morning meetings. Goodwin adopted Jack Welch’s (former CEO of General Electric) method of ranking employees on

124 Market as ideology performance. The problem with this was that, if a manager wanted to move a well performing subordinate up to the “top performance” category, he or she had to move another manager down, since each unit had to comply with the “Bell curve” (it was a zero-sum game). Very ambitious budget targets, often considered unrealistic by those who had to live up to them, set the stage for internal competition rather than co-operation. The failure of a colleague was seen as an opportunity. You had to allocate all your time to meet your own targets; there was no time to help colleagues. Employees were disciplined under the yokes of PEF (Performance Evaluation Framework), and LEP (Leadership Excellence Profile), which were open to subjective abuse (Kerr & Robinson 2012). To further extend control over information, Goodwin and the communications director Howard Moody initiated stronger control over contacts with external stakeholders, even consultants could not be used without Goodwin’s authorization. Goodwin also engaged in litigation concerning defamation as journalists criticized aspects of RBS. One spectacular event was his effort to “slap” an injunction on a building company erecting a department store building on St Andrew Square. The reason: it left specks of dust on Goodwin’s Mercedes parked nearby. Expansion In the early 2000s Goodwin turned his attention to Ireland, where the economy had grown rapidly over the last few years as a result of tax incentives and de-regulation that went a bit further than competing members of the EU. RBS had acquired Ulster Bank in 2000, a well-run bank ranking as number three in the country, and had centralized its credit process to free staff to devote more time to selling. But Goodwin wanted a larger share of the growing economy. He found the solution in Cormac McCarthy, the young CEO of First Active (an Irish mortgage bank). The timing was right since First Active had been made a limited company (formerly a mutual building society) five years earlier, and the ban on concentration of ownership was about to be lifted. McCarthy was offered good terms (to become CEO of Ulster Bank after the merger); his finance officer would follow him to the same position in Ulster Bank and a number of non-executive board members would be given a place in the new entity. Analysts were concerned that the offered price was three times the book value of First Active’s assets, but the deal went through. Now Ulster Bank embarked on a journey to become the number one bank in Ireland (J21 (journey to one) for short). The pressure to sell increased. Soon Ulster Bank was the first to offer mortgages at 100% of the property value. An illustration of the atmosphere at the time is the Dunne affaire: sensing the overheated market, the owners of a large site including two premium hotels in Ballsbridge, an upmarket suburb, wanted to cash in by putting it up for auction. Dunne, a rich property developer, arranged funding with his usual banks, Bank of Ireland and Irish Nationwide (275 million Euros) to enter the bidding. Ulster Bank approached Dunne with a better offer to take over the financing; credit for the

Market as ideology 125 whole sum of purchase, and a further 130 million Euros to buy an adjacent office building. This was the most expensive commercial property site in the world for a while. Before Dunne could obtain planning permission, however, the financial crisis struck and Dunne went bust. Ulster Bank had syndicated some of the loans to Rabobank and Kaupthing (among others). The credit loss seems to have been absorbed. On the surface the figures of Ulster Bank looked good for 2007. In 2002 Goodwin was named the Forbes Global Businessman of the Year. His position was very strong. Fraser has a chapter named “Royal Bank of Fred” with tales about extravagant expenditure on activities only remotely related to the business of the bank, like involvement in Formula 1 racing (the Williams team) and in golf, seven limousines on duty 24 hours a day all days of the week, a corporate jet. (By now the new regulator (FSA) had found its role as a quite lax regulator.) The American build-up Goodwin considered growth in the USA the best option. The Labour government had stopped Lloyds’ attempt to take over Abbey National in 2001, acquisitions in Europe were unattractive because of the cost of laying off people there. In the USA take-overs as well as lay-offs were less regulated. And the RBS American arm, Citizen Financial, had a smooth operator in Larry Fish, who had acquired smaller banks seemingly successfully at a rate of two a year for some time. However, those acquisitions were usually paid in cash using the RBS cash flow. Now, when pushed towards larger deals Fish’s tendency to overpay for acquisitions came under scrutiny. A triangular drama between Charter One (that was courted by KeyCorp) and RBS (intending to bid on KeyCorp) ended in RBS acquiring Charter One after only three days of due diligence at a quite high price (10,5 billion USD cash, the largest cash transaction in the history of US banking). The deal was considered a bad one by Mathewson, and by analysts; RBS shares fell 5% on the day of announcement in May 2004. Charter One had pointed out how well they were doing in HELOC (granting consumer credit with homes as collateral – not subprime mortgages). In this situation a non-executive board member of RBS, Peter Sutherland, commissioned an opinion poll of how investors saw the RBS, its strategy, management team etc. The report, ready by May 2005, was devastating for Goodwin (claiming he did not listen, was arrogant, treated shareholders like idiots, etc.) as Sutherland read out parts of the report at a board meeting. Hostilities with analysts came to the fore at an analysts’ conference in August 2005 where there were questions about a “management discount” on the shares due to Goodwin’s deal-making. (The market saw management as a weakness in evaluating the share price.) After the board meeting, with Sutherland’s report reading, Goodwin seemed a different person stating that he saw no need for further acquisitions. But, before long, it was announced that RBS

126 Market as ideology would form an alliance with Bank of China (11,307 branches in mainland China), which meant acquiring 10% of that bank. A solution had been found whereby two other (passive) partners would acquire about half of this. Goodwin tried to calm analysts by pointing out that the deal would be funded chiefly by the sale of RBS’s stake in Santander (at 900 million GBP). The summer of 2005 also included the sudden resignation of the RBS director of finance (with “be more with the family” reasons given), and the appointment of a successor recruited from Citibank, but without experience as director of finance. He had, however, participated in the installation of an IT-system for credit derivatives at Citibank, a system that was rumoured to focus on hiding toxic assets (Fraser 2014, p. 212). By now the production of toxic assets via very high leveraged banks creating a system of interlinked traders that did a lot of trading between themselves,was at its height. The volumes of trading required a large balance sheet. The fastest way to increase the balance sheet was by acquisitions (including the goodwill that came with overpriced incoming assets), and by lifting the “market prices” of financial assets by such mutual trading. ABN AMRO GOODWIN’S BIGGEST MISTAKE

ABN AMRO had sought growth over the first part of the 2000s but was underperforming. Goodwin was interested in ABN because of its Chicagobased subsidiary, LaSalle Bank, that could be merged with Citizen Financial to hide the fiasco with Charter One. Contacts with Santander showed that they were primarily interested in the Brazilian subsidiary of ABN AMRO, Banco Real and the Italian one Banca Antonventa, while Fortis saw an interest in taking over ABN’s BeNeLux operations. While this consortium was forming, Rijkman Groenink (the boss of ABN AMRO), who saw RBS’s interest as hostile from the beginning, had initiated negotiations about a merger with Dutch rival ING. This came to nothing since ING would not pay enough for the shares of ABN. The low performance of ABN had drawn the attention of several hedge funds, however. These funds put pressure on Groenink to achieve a turn-around, or else. On 1 March 2006 RBS reported pre-tax profit that was 17% above the previous year. A couple of weeks later it was announced that Barclays was about to bid on ABN AMRO. Goodwin seemed to have panicked – he had thought Barclays itself was likely to be targeted for a take-over – now, while they were themselves bidding, Barclays would be “bid proof”. This could mean that the focus of interest might be directed toward RBS instead. Fortis, RBS and Santander met in early April to work out a deal between themselves as the basis for their offer. The agreement was that ABN AMRO would be divided between the three, with RBS getting LaSalle, the Asian operations and investment banking in the USA, while Santander would get the Brazilian and Italian subsidiaries, and Fortis the BeNeLux operations. The agreement was legally binding for the rest of the acquisition process. The problem was that in the next few days Groenink sold the LaSalle Bank to Bank of America (at a price of 21 billion USD). This was described in the

Market as ideology 127 press as a “poison pill” to avert RBS interest in ABN AMRO. Goodwin was furious and took this as a personal insult. Due diligence was insufficient, the consortium now justified the acquisition with a claim that they could achieve considerable cost savings. A US court had confirmed that ABN AMRO had the right to sell LaSalle at the stage it did. Now ABN AMRO had two competing bids (Barclay’s and that of the RBS consortium) and the board refused to recommend either of them to shareholders. Furthermore, the risks in the subprime market had been noticed, and Moody’s started to down-grade mortgage-backed securities in July. Northern Rock issued a profit warning at the end of July. BNP Paribas suspended three funds exposed to that market on 9 August. The next day the European Central Bank pumped 94.8 billion Euros of liquidity into the market. That same day RBS held its shareholders’ meeting, which voted to affirm the offer to take over ABN AMRO. By September Barclays’ shares started to decline – their offer was based in shares – which improved RBS’s prospects to win the battle. When the Dutch authorities accepted that the consortium could buy ABN AMRO, they appended very strict conditions, including that RBS must take responsibility for the whole of ABN AMRO as the bank was dismantled, and obtain regulatory clearance every step of the way. Investor discontent with the deal grew after Bloomberg publicized it, on 8 October. Later, when speaking to the Treasury select committee in February, Goodwin admitted that it was a “bad decision” to acquire ABN AMRO. RBS had to borrow the majority of the payment for the deal on short terms (payable within a year), Several surprises were discovered after the take-over (for instance, 725 million USD invested in Madoff’s Ponzi scheme), that ABN had shouldered 840 million USD risk in one of Goldman’s synthetic CDOs, and that ABN had lent tens of billions to Russian oligarchs. The integration process also got stuck in cultural clashes. On the RBS side, Tom Killop (Chairman) and Goodwin (CEO) claimed, from 2005 to 2007, that RBS was not doing “subprime” in spite of the fact that RBS was the third largest underwriter and bundler of US housing debt. In February 2008 RBS announced record profits (10.3 billion GBP) and a raise of dividends, but they were also pressured by authorities to undertake a 12 billion GBP rights issue (to increase equity). Suspicions about the quality of its assets and liabilities grew. Time was running out. By 11 October 2008, in a meeting at the Treasury, the RBS leaders were told that RBS had to sell 20 billion GBP of equity to the government as part of the bailout (almost double the current capitalization (10.9) of RBS at the time), and that it had to abstain from paying any dividends until the 5 billion GBP preference shares part had been redeemed. Goodwin and McKillop had to go. DIFFICULT TO DISCERN A BUSINESS MODEL FOR ROYAL BANK OF SCOTLAND

No doubt the RBS had a business model before de-regulation. It was traditional banking and there was fierce competition with “the old bank” (Bank of

128 Market as ideology Scotland) for Scottish customers through a wide net of branches. It must have been hailed as a great victory when the bank managed to acquire the National Commercial Bank of Scotland, in 1970 to gain a 40% market share and a number of branches throughout Scotland. However, a shattering experience soon followed with the Standard Chartered take-over bid in 1981, countered by a competing bid from HSBC (and the bank’s leaders knew that Lloyds and Deutsche Bank were preparing something along the same lines). When the Board of Directors recommended shareholders accept the bid from Standard Charters the Thatcher government intervened to stop the merger. This weakened the position of top management in RBS and help was called in to revise strategy. The “new strongman” was Mathewson, without banking experience, but with a passion for Scottish development. The restructuring plan (Nova Reda) was worked out in “secret meetings” and implemented quickly and forcefully, “shaking things up”. A new approach, branding, sales, and centralized management, was confirmed by another restructuring in the mid-1990s. Now the bank was ready to go global, via Citizens in the USA (successful) and into Europe via an alliance with Santander (not very successful). The first application of a more expansionist, but soft, approach to take-overs, the Barclays affair, ended in nothing. But there was considerable success with the NatWest take-over. Here Mathewson and Goodwin worked well together, probably because the bid had been well prepared in the due-diligence phase. Goodwin, however, took all the credit for the project. Mathewson’s move up to the chairmanship left Goodwin in charge of an organization trimmed to being controlled from the top. Goodwin’s “infallibility” and his knack for PR drove him into a series of bold but improperly prepared ventures that finally failed. The last decade of the bank’s time as independent bank seems to have been oriented by betting on emerging opportunities, rather than by strategic plan. The judgement of Goodwin’s reign must be harsh; the arrogance is astounding as read at a distance via Fraser’s book, and some newspaper clips. The Board of Directors should have forced Goodwin to slow down, justify, and re-consider strategy. The turmoil leading up to the financial crisis offered RBS too many options at once and, with the new (unfounded) confidence in his capacity to manage them all, Goodwin had led RBS to become a victim of Strategic Stress Syndrome. While Barings Bank did not have the internal control system (and capital) to monitor its expanded East Asia business, RBS had a leader who thought he could do nothing wrong. It should be noted that the de-regulation of the 1980s, in the name of freedom and market solutions, resulted in free movement of predatory, financial capital and a hectic take-over merry-go-round, which shattered “normal” business models to be replaced by defence strategies to avoid “coming into play” or predatory attacks. Traditional banking as we know it suffered. Attention had shifted from managing operations to profit by growing asset values (holding gains, as it were), and (“market”) power. Only “creative” accounting concerning financial instruments and a (virtually) free valuation of them in

Market as ideology 129 balance sheets kept banks (and GNPs) growing. Piketty (2014) reminds us that this has been accompanied by an accelerating transfer of resources from the poor to the very rich. It is reasonable to assume that this is not a sustainable development. It may be unfair to blame the shift in micro-economic thinking from the original focus on management’s operational decisions to the perspective of the investor aiming for shareholder value, but it seems well worth the effort to consider RBS an illustrative case of this such a shift. As mentioned, this case is similar to the Washington Mutual (Grind 2012) and several others (cf. Financial Crisis Inquiry Report, FCIC 2011), so even if it is a single case it may be considered representative of the managerial activities in many banks destroyed by the financial crisis (and often saved by the State). By focusing on rapid growth of the balance sheet to gain financial power by further leverage, top managers saw acquisition as the best strategy. Once acquired, the “integrated” new parts of the growing bank were pressured to increase sales and cut costs at the same time. Investment in systems to back up corporate governance documents produced with PR assistance was not an attractive option. Centralization of decision power to ambitious leaders with the talent to spot opportunities and to exploit them quicker than others was a requirement for such a strategy to be executable. The risks of ghosts emerging from multiple closets increased in the process. The rhetoric in vogue at this time was neo-liberal. The State is clumsy, bureaucratic and inefficient, while the Market is agile and innovative, always finding the solution and, therefore, the right price, much quicker. The only requirement is to allow the creative market actors to get on with it without unnecessary obstacles. (Liquidity infusions to stabilize markets were welcomed, though.) Part of the innovative character of the market is that individual, well informed, and competent actors in the market may be allowed to outsmart other actors. In this way the whole society will benefit as rents gained in market transactions “trickle down” to everyone. However, Piketty (2014) has shown that, if anything, they tend to “trickle up”. “Survival of the fit” in a competitive environment will provide a basis for an ideology that can produce arguments for success as criterion, whatever the method. It also sets the stage for the use of power to gain an upper hand. Organizations in competition will, as a matter of course, promote the best leaders to the highest positions. After all it is in the organization’s best interest to apply such a policy, with strong leaders emerging out of chaos. It is here that the gap between macro and micro becomes visible, as is illustrated in the case of RBS. Most members of the organization for a long time thought there was no doubt that Goodwin was the best leader, even if they resented his arrogance and his lavish spending habits. Let us look at this through the glasses of agency theory. Agency theory (Jensen & Meckling 1976) has two actors; the principal and the agent. The agent is a self-interested person who needs incentives to work for the right thing. He is, therefore, not to be trusted, and needs monitoring due to “moral hazard” and other risks of misbehaviour. The principal, on the other hand, we do not know very much about. He is risk neutral and knows

130 Market as ideology how to calculate (perhaps modelled after Plato’s Philosopher Kings). He also worries about whether the agent has more information than the principal. But the principal has the power to set whatever goal for the organization he pleases. In modern terms that goal is shareholder value. In order for this to hang together we have to assume that the shareholders elect the members of the board to serve as proxy principal. The board in turn selects the CEO who runs the company on behalf of the principal and thus is an agent in need of monitoring. Here it is quite clear that the agent has all the information and the board is at the mercy of the CEO to be provided with the information they need. Not to worry!, says the neo-liberal ideology; the market will discipline them all. If organizations are not performing to standard it will punish them with corrections of the share value as value-seeking shareholders turn elsewhere. (But how will the market know if not even the board knows?). In order to avoid punishment, the CEO (incentivized by rewards tied to the share value) will strive to achieve a return on equity on par with other comparable organizations. In a world of insufficient (or overwhelming) information it will be easier to reach this goal by manipulation rather than by sustained efficiency improvement. Innovation might be an attractive option, but an uncertain one. Now look at the case of RBS from this perspective. Mathewson was recruited from the outside. He was different in the sense that he had analytic training, but he was keen on the development of Scotland and thought that the key to success would be firmness in the pursuit of efficient banking. He disciplined the RBS to make it ready to welcome Goodwin. Mathewson embraced the multi-brand strategy that allowed control by metrics and fast expansion. Goodwin took command by using temper and abuse to get his way. Rewarding success and punishing poor performance, he removed control mechanisms, first by replacing a stubborn auditor, then by setting several corporate governance features out of order, and, finally, by working by committees that he dominated, feeding information to the board on a “need to know” basis. The board became, in time, a captive audience, and the chain of command prescribed by agency theory was broken. Goodwin had taken over the seat of the principal. It seems like power games, which are not part of agency theory, sort out the “best” candidate for the role of principal. When the principal is not disciplined by corporate culture, the organization will easily turn into an instrument for the strivings of the current principal. RBS lost its corporate culture (placid as it might have been up to de-regulation) with Mathewson and Goodwin (strongwilled outside recruits) and also lost its sense of direction. What drove Goodwin over the last period seems to have been his fear of RBS being taken over by other players. To “be in play” is not desirable if you are the principal. Size is the best protection against that. 4:5:2 Case 6. The rise and fall of the Icelandic banks I believe it is difficult to imagine how small Iceland actually is when you consider the three rather gigantic banks that emerged in this country of 350,000

Market as ideology 131 people. The land itself is quite barren with black lava fields on both sides of the route 1 when you go on a trip around the island. The black lava is rather “wavy” and decorated on the top by olive-coloured moss. Quite impressive! Now and then you will see riders training the adorable ponies for export. My first visit to Iceland was in 1996 when I came to persuade the University of Iceland to join the Nordic Academy of Management. We went to see the geysers and arrived at Tingvallir, the place where the people met to take democratic decisions a thousand years ago, coming up on the “back road” so to say (not by the road straight from Reykjavik). We could see that something was going on, and soon we stood face-to-face with the royalty of the Scandinavian countries and the president of Finland. Iceland was celebrating 50 years as an independent republic. At Tingvallir, by the way, you can see a museumlike room that grows a couple of centimetres wider every year – Iceland is situated on two of these continental plates that are drifting apart. It is a volcanic land – I walked on a beach that was totally black. Strange! You can visit the place where Snorre Sturlason lived (and might have washed his feet in the little pool where I sat down to ponder) and the imposing building in down-town Reykjavik, where all the sagas are kept. A community-like society if there ever was one! We have had students from Iceland at my department for a long time. One of the first students wrote his master thesis on inflation in Iceland and how people coped with it. The problem was that inflation was seasonal and there were two (fishing) seasons when inflation reached up to 40% and then calmed down for a while and then, when the fishermen landed the catch of the next season, prices went up again. To borrow money from the bank you had to be well connected, and if you were, you could buy a house and let inflation pay for it. Then there was a period when the benefits of thermal heat (and electricity) were exploited. Alcoa set up a smelter for aluminium. Cheap electricity could also be used to daylight lamps in greenhouses that were heated by a pipe stuck into the ground and up comes very warm water. You could grow tomatoes here for export, or orchids! There is the matter of transport, of course, but the sales argument is – no pollution. Creative minds can find ways to earn a living in Iceland! This is a tradition since Leif Erikson discovered America. But, nowadays the main business is tourism. Icelanders tried international banking for a while, too. The question, then, is, how could such a small country (350.000 citizens), with such limited opportunities to make a living (and with 30 (savings) banks when it all started) generate so much fuss about banking? Explanations for the collapse of Glitnir Bank hf., Kaupthing Bank hf. and Landsbanki Íslands hf. are first and foremost to be found in their rapid expansion and their subsequent size when they tumbled in October 2008. Their balance sheets and lending portfolios expanded beyond the capacity of their own infrastructure. Management and supervision did not keep up

132 Market as ideology with the rapid expansion of lending. Growth in lending by the banks’ parent companies averaged nearly 50% from the beginning of 2004 until their collapse. The banks’ rapid lending growth had the effect that their asset portfolios became fraught with high risk. Numerous examples in the report corroborate that conclusion. (SIC,Althingi Iceland 2010) Like the banks of Seville, the banks of Iceland that failed in 2008 like so many other banks around the world, need to be looked upon as a group, not least because of the limited context in which they were conceived. The reason for this is that these banks, Kaupthing, Glitnir, and Landsbanki, have a very short history as big banks with international operations. They all came to this role as a result of de-regulation, and they all became captives of their large owners and debtors, with desperate efforts at the end to repair damages by all kinds of “tricks” against the background of neo-liberal deregulated self-interest. I will give the account for the adventures of these banks by first describing the development of Kaupthing largely based on its own account via the Annual reports from 2004 and onwards. Then I will give short accounts of the two other banks to complement the Kaupthing account. Finally, a different perspective on these events is provided by an extensive account of the Special Investigation Commission Report (2010) to the Althingi (Parliament). Together this will give an image of amateurish, bold projects undertaken in the wake of de-regulation and Iceland’s entry into the European Economic Area (EEA), an agreement that gave three of the four remaining EFTA countries access to the inner market of the EU. (It should be noted that Iceland applied for EU membership after the financial crisis of 2008, but the election of 2013 changed the majority in the Althingi and the application was withdrawn.) The access to the inner market of EU also provided, seemingly, unlimited access to credit, and good credit rating (the Central Bank of Iceland was, it seems, considered a safe lender of last resort). The final saga about international banking in Iceland came to be characterized by desperate action to keep the inflow of money in pace with short term debt generating due dates for payment as creditworthiness faltered. Kaupthing Bank A SHORT HISTORY

In 1930 the State started the bank Búnaðarbanki as fully owned by the state. In 1960 it began to open branches all over the country. In 1982 the government granted Búnaðarbanki licence to conduct currency trading. New legislation in 1986 gave commercial banks freedom to set their own interest rates. De-regulation of trading in foreign currencies for import and export came in 1992. The government’s strict supervision of financial transfers was lifted in 1995. In 1998 Búnaðarbanki became a limited liability company and work began to

Market as ideology 133 privatize the bank. It was listed on the stock exchange from December 1998. This process was completed by the merger with Kaupthing Bank in 2003. The Kaupthing Bank was established in 1982, at the start of the free capital market in Iceland. The founding members sold 49% of their shares to a group of savings banks. In the same year the Iceland Stock Exchange started with Kaupthing as one of the first five founding partners. In 1990 Búnaðarbanki acquired 50% of the shares in Kaupthing and, as a consequence, had an equal owner share with the group of savings banks. In 1996 the savings banks acquired the remaining shares in Kaupthing from Búnaðarbanki. This ownership was stable until the Kaupthing shares were listed on the stock exchange in October 2000 after the savings banks had reduced their holdings. Kaupthing itself (“Bank” was added later) had grown rapidly in investment banking in Iceland. It established the first mutual fund, and was the first to establish a branch abroad (Luxembourg). It obtained a licence to operate as an investment bank in 1997 and commercial bank in 2002. In connection with the merger in 2002 with Búnaðarbanki, Kaupthing added “bank” to its name. It built its international operations by acquisitions (broker house Sofi Oyj in Finland, and JP Nordiska in Sweden). In 2004 Kaupthing acquired FIH Erhvervsbank A/S (Denmark) and in 2005 Singer & Friedlander Group plc (England). By 2005 70% of the revenue was generated abroad. A CLOSER LOOK

The business model of Kaupthing bank as it is portrayed in the 2004 Annual Report (AR) seems quite conventional, even if somewhat over-ambitious (as if written by a student):       

Maximise the Bank’s value and long-term shareholder value Achieve 15% long-term return on equity Be a leading bank in Iceland and one of the prime investment banks in the Nordic region Sustain rapid growth without compromising profitability Develop and sustain dependable, long-term relationships with customers Employ motivated, well-educated and enterprising staff who are experts in their respective fields Continue to develop the Bank’s workforce as the most valuable asset

“Comprehensive financial services” is a recurrent theme in comments on the business year 2004. Those services generated a 22.6% return on equity (above the 15% goal). The Bank more than doubled its assets during the year by the acquisition of Danish FIH Erhvervsbank from Swedish Swedbank (the previous owner). Moody’s upgraded Kaupthing’s credit rating, from A2 to A1 for long term deposits and senior debt, and from A3 to A2 for subordinated debt. Financial strength was affirmed at C+. Icelandic investors may have wondered about the meaning of these new measures of creditworthiness. In February the

134 Market as ideology Bank acquired the Norwegian securities company A Sundvall ASA. In May it entered into a Limited Liability Partnership with eight partners in the UK, called New Bond Street Asset Management, to start a fund manager. In November a subsidiary of Kaupthing acquired PFA Pension in Luxembourg to improve its client base in Private Banking. In December the Finnish supervisors granted the Finnish subsidiary of Kaupthing its banking licence. Kaupthing had been granted five banking licences over a short time (in four Scandinavian countries and Luxembourg). A policy statement in the 2004 report gives the subsidiaries in the various countries independence to build a local identity. Management was only centralized in areas vital to the organization’s shared identity and mission, the statement claimed. The stated principle thus was that subsidiary managers were free to pursue established goals in the way they chose, within the framework set out by the Bank. But as the Executive Chairman said, they invariably used the platform of the group and benefits of its international network for better results. Fast growth in Northern Europe was emphasized, with eight acquisitions of Scandinavian companies in a period of four years, among them a Swedish bank, JP Nordiska (“we are proud to have transformed JP to a profitable and growing business”). Kaupthing now had operations in ten countries organized into six business segments (or profit centres), in addition to ancillary units. The Investment Banking Division was one of the major contributors, and an increasing proportion of international projects was said to become a still “greater focus” in coming years. The policy concerning risk-taking was said to be to “ensure that lines of communication remain clear”. Strengthening the Bank’s position in London was of vital importance in this respect. The former CEO retired at the end of 2004, and his young successor Hreidar Mar Sigurdsson stressed that 2004 had been “a strong year” and pointed to the Moody upgrading of its rating of the bank. A new line of business had been opened as the Bank had started (in August) to compete with State-owned House Financing Fund (HFF) by offering mortgages at highly competitive rates. Already at year’s end Kaupthing had won 7% of the market. The Bank was busy implementing IFRS accounting standards. This implied substantial changes in accounting principles (but the standards were not yet in place). The comments on the Bank’s shares noted an increase by 96.9% in 2004. The major shareholder (Meidur) owned 16.98%. The bank had also purchased a large number of its own shares in fulfilment of employee stock option agreements. During 2004 the loan portfolio (25% to real estate and trading customers) increased by about 300% (Danish FIH accounting for 170%). The cost/income ratio was 50.2% (down from 58.2% the previous year). The number of employees was now 1,600. The year 2005 brought new records, assets almost doubled, operating income more than doubled, and cost/income came down from 50.1% to 34.1%, which is very good for a bank – but were there enough staff to manage it all? Well, the AR for 2005 reports the number of employees at 2,400

Market as ideology 135 (50% increase). The first claim made in the text part of the AR was that Kaupthing was “one of the fastest growing financial groups in Europe”. Growth was obviously a primary objective, like with most other banks at the time. Otherwise the Business Objectives were slightly altered. Instead of the previous years’ 15% long-term return on equity this was now “at least” 15%. The previous year’s “rapid growth” was now “solid growth”. The sentence about being “a leading bank in Iceland” had been dropped. “Customers” had been replaced by “clients”, and there was a new sentence about incorporating the latest information technology. The most significant news in 2005 was the acquisition of the London firm Singer & Friedlander, which doubled the assets at a price of 547 million Euros. Fitch awarded the bank the credit rating A for long term and F1 for short term. Strategy was focused on increasing income diversity, enhancing asset quality, and broadening services. It was pointed out that impairment of loans was lower than it had been previously. Those improvement issues could be read as a call to “more of the same”. The Executive Chairman in his letter brought up all the questions he had received from share holders about what the secret was behind the bank’s success. He always responded that there was no secret. His explanation was the unique culture of Kaupthing, its flat structure and disciplined decision process.“Mid-sized companies and affluent private clients” was the market focus. The CEO letter used the word “prudent” frequently, and celebrated the ambition to take steps to make the bank a leading bank in Northern Europe. The Kaupthing shares were better than European banks in general and they out-performed the Stockholm stock exchange index. Another group (Exista) was now the largest shareholder (21.2 %). Kaupthing reported that it sold 8.5 million of its own shares during the year almost exhausting the stock of shares acquired the previous year. Employees now owned 7.2% of the shares, mostly by virtue of the stock option program. The credit process was explained in a flow chart and there were extensive text and diagrams outlining the process of risk analysis. The Basel II rules for capital coverage were also explained. Kaupthing was going to opt for Standard Approach initially (already partly installed), and move on to the Advance Measurement Approach (AMA) later. Things were going well for Iceland with a higher GDP growth rate than in many years (4.75%) In 2006 everything was better than the previous year, although growth was a bit more modest. Earnings per share were clearly better, C/I slightly higher, up to 35.8% from 34.1% in 2005. (This was still quite low in comparison with other banks – a worried shareholder might have seen this as indicating a lack in administrative capacity.) The Executive Chairman’s letter pointed out “a radical change” in how the Bank was perceived. From being an Icelandic bank it was now seen as a northern European banking group. It was proof of the strength of the business model that the bank had achieved growth without qcuisitions in 2006. The CEO (on his part) was pleased with the record earnings, particularly since there had been doubts concerning the imbalances of the Icelandic

136 Market as ideology economy and speculations about the effects this might have on the bank. “Cross-selling” and “inter-office cooperation” was mentioned as contributing to performance. International analysts had shown concern about the “systemic risk of the financial sector in Iceland”. Some investors withdrew, but Kaupthing stood firm and weathered the storm. Some of the action was to unwind cross-holdings in Exista, and to extend the funding sources by issuing bonds to investors in the USA, Australia, and Japan. Prospects for the future were good, said the CEO, but one had to remember that a company like Kaupthing was dependent on a variety of external factors that might impact its operations. Even if net revenues and return on equity came in somewhat below the previous year’s figures, the year 2007 was described as a “strong performance” by the Executive Chairman. After all, the 23.5% return on equity was above the stated 15% goal. Liquidity was strong and secured for 440 days. Although the outlook for financial markets was uncertain “Kaupthing occupies a strong position”. The AR for 2007 mentioned two things of strategic importance. First, the announced acquisition of the Dutch bank NIBC was cancelled. The Chairman remarked that, since that acquisition was already funded, the cancellation left Kaupthing in a strong liquidity position. The reason for this cancellation is curious. Problems started as Fitch tested a new assessment method, which led to a downgrade of Kaupthing’s credit rating. There was, however criticism of this new method from several of Fitch’s clients. Fitch recanted and returned to its old method and reinstated Kaupthing’s rating. (Since Fitch’s customers were paying for the rating, the fact that they did not like to be down-graded might have had something to do with that.) This maneuver had drawn attention to the quality of the NIBC acquisition. Another rating institute, Moodys, decided to place Kaupthing under review for a possible downgrade of its rating since the NIBC acquisition might weaken Kaupthing’s financial position. Finding themselves under review by Moody’s caused the bank to withdraw from the acquisition. Kaupthing Bank’s CEO claimed that the decision was taken because the financial markets no longer permitted the realization of the planned “synergies”. Second, there was a “strategic” change in the funding orientation by Kaupthing toward increased reliance on deposits. This is described as connected with the introduction of a new retail savings product called Kaupthing Edge, which was successfully tested in Finland and Sweden and now was on its way to the UK. The response was better than expected and a new goal for funding was set – to increase funding by deposits to 50%. (It was this new kind of digital deposit at a very attractive interest rate that caused the demise of the Icelandic banks. As usual a large number of pages in the Annuat Report deal with risk management. Of particular interest is the section on structured credit instruments (ABS – asset backed securities, and CDO – collateralized debt obligations (in this case “synthetic”)). In late 2007 Kaupthing took action to limit its exposure

Market as ideology 137 toward such structured credit risks, which meant that part of the ABS portfolio was sold and a credit line, linked to ABS exposure for New Bond Street Asset Management (NBSAM), was withdrawn. As to the CDO portfolio it is said that the underlying assets are rated A or higher. For the first time the AR mentions the quarterly stress test performed by the supervisory authority; “a simulation technique used on assets and liabilities to determine their reaction to different financial situations”. The severe assumptions used in this simulation are shown and it is claimed that “the test shows that the Bank’s capital ratio remains strong”. The strength of the Bank’s position is explained by the fact that during 2007 it had managed to raise 15.3 billion Euros in the long-term wholesale market and in new deposits – this should be compared to the expense (to redeem loans due) of 3.6 billion Euros for the Kaupthing group as a whole in 2008. Further funding needs in 2008 would be quite limited. The largest shareholder was still Exista BV (23.02%). (It is not mentioned that extensive loans were granted to those owners to be able to buy Kaupthing shares – to stabilize the share price – which was later exposed in the court proceedings.) During the year the number of employees increased from 2,700 to 3,300. This had an effect on the C/I ratio, which increased from (very good) 35.8% to 47.5% in 2007 (more normal). This is, the AR points out, still below the 50.0% goal (which had not been mentioned as a goal before). In sum: things looked pretty good in spite of the imbalances of the Iceland economy. Landsbanki When the Althingi (Icelandic Parliament) established the Landsbanki (in 1886) it was in order to support necessary industrial development. Resources were limited, which made the bank focus on a type of activity that could be described as a savings and loan society. However, with the new century, industrialization took off and Landsbanki grew in step with the economy. By the 1920s it was the largest bank in Iceland and was put in charge of the issue of bank notes. (This task was transferred to the new Central Bank of Iceland in 1961.) A branch network was established and Landsbanki assumed the role of an ordinary commercial bank. In connection with this the State ordered it to merge with the Samvinnubanki (Cooperative bank). De-regulation, from 1986, led to a privatization of the bank (into a limited liability company). This operation was concluded in 2003. By then Landsbanki had already started its internationalization by, as the first Icelandic bank, setting up business in England, and acquired the Heritable Bank (London) in 2000. In 2005 Landsbanki acquired three European financial houses dealing in securities: Teather & Greenwood (London and Edinburgh), Kepler Capital Markets (Paris), and Merrion Capital Group (Dublin). Landsbanki had its own branches in London and Amsterdam specialized in structured finance and asset-based lending. A branch in Luxembourg handled private banking. In August 2007 the bank acquired the UK investment bank Bridgwell plc, which was merged with Teather & Greenwood under the name Landsbanki Securities. This made Landsbanki the second largest broker

138 Market as ideology firm measured in number of clients. In December 2008 Kepler Capital Markets was sold to its staff (management-buy-out). Icesave In October 2006 an on-line deposit service was launched in the UK market. It was successful from the start, and it changed the funding profile of Landsbanki. By the first quarter of 2007 more than 80,000 accounts had been opened with GBP 2.8 billion in deposits. The sales pitch for the Icesave accounts was an interest rate guarantee of at least 0.25% above the Bank of England base rate until 2009 and thereafter not lower than the base rate. Icesave became the market leader in internet deposits. From May 2008 the same product was launched in the Netherlands. On 7 October 2008 the Icesave stopped service (deposits as well as withdrawals). On 8 October Icesave was declared in default, bringing down Landsbanki with it, as the British government froze all Landsbanki assets in the UK. In 2013 the EFTA Court cleared Iceland of the charges that the State of Iceland was the guarantor of the Icesave deposits. This meant that there was to be no loan agreement between the Iceland State on one side, and the UK and Netherlands on the other, to guarantee claims from Dutch and British deposit-holders to receive the Icelandic minimum deposit guarantee. However, the claims still exist toward the Landsbanki in receivership as a “first priority claim”. The last estimates are that this priority claim on Landsbanki in receivership will be paid by the end of 2017 as the bank’s assets are liquidated stepwise. One can only imagine the legal complications and processes surrounding this issue. Glitnir Glitnir was created in 1990 by the State in a directed merger between the three privately held banks (Alby∂arbanki (Union Bank), Verzlunarbanki (Bank of Commerce), and Iöna∂arbanki (Industrial Bank)) and one failing publicly owned bank (Utvegsbanki (Fisheries Bank)) to form Islandsbanki. It was listed on the Iceland Stock Exchange from 1993. It merged with the FBA Icelandic Investment Bank in 2000. Even if Glitnir was engaged in universal banking, and was a notable actor on Nordic stock exchanges, it was a leading bank in the seafood industry, sustainable energy, and off-shore supply vessels. It had branches in London and Copenhagen, a fully owned bank in Luxembourg and a string of financial services companies in Norway. Norway, considered as its second home market, had been built by acquisitions starting in 2004 with BNbank, then Kredittbanken, and Norse Securities. There was also Glitnir Kapitalforvaltning and Glitnir Factoring, 50.1% of Union Gruppen, and 45% of Norsk Privatøkonomi (with 12 offices in Norway). In 2006 the broker Fischer Partners in Sweden was acquired. In 2007 68% of the Finnish investment firm FIM was acquired. Glitnir reported 39.4% return on equity after taxes in 2006.

Market as ideology 139 A third of the company was owned by a group called Stodir. A large share of Stodir was, in turn, controlled by the Baugur Group, which was owned by a number of companies with addresses in a single mailbox in British Virgin Islands. THE COLLAPSE

On Monday 30 September 2008 it became clear that Glitnir had approached the CBI for help because it foresaw liquidity problems by the middle of October. The CBI did not trust the offered collateral and decided to buy 75% of Glitnir’s shares at a low price (in all 600 million Euros). Now credit lines were withdrawn from the two remaining banks, and there was a bank-run on the Landsbanki branch in the UK managing the Icesave accounts. The Landsbanki could not meet the payment demands of its creditors, and fell. Telephone calls between ministers in Iceland and the UK did not solve any problem. Relatedly, the British government seized Kaupthing’s Singer & Friedlander, which brought Kaupthing down. “The Icelandic business model appears to have involved transforming non-financial firms (now heavily leveraged) into an investment fund, be they shipping companies such as Eimskip (established in 1914), airlines such as Icelandair (established in 1943) or fish-exporting companies” (Zoega 2008a). In his analysis of the lessons learned from the collapse Zoega (2008b) refers to Olson’s (1965) Logic of Collective Action and its claim that the difficulties of holding a large group (of differing interests) together may be less challenging if we apply the reasoning to a small country – we may also remember Hayek’s Road to Serfdom, where he claims that the State can never keep track of all the desires of its citizens, much less satisfy them all. Zoega (2008b) points out that the smaller the country the more likely it will be uni-polar. In the Icelandic case the government, the Central Bank (CBI), and bank managers made mistakes together (knowingly or not). They fall together. It seems like the different players are able to hold each other hostage in a particular manner. The Special Investigation Commission (SIC) of the Parliament (Althingi) argued that normally a bank that is about to grant a lone to a company is in a position to dictate the terms of the credit, but if the loan is such that the bank risks losing large amounts on earlier loans if the company fails to meet its obligations, the situation may be the reversed. The same goes for a country with a too large financial sector (10 times the GDP). The Central Bank and the Government knew that if they tried to stop a threatening development, they would be sure to cause large damage to the economy. They may have been ready, instead, to bet on even a tiny hope that the banks would bounce back. (It should be noted that I have tried to simplify the account of what went on in the Icelandic banks as much as possible while maintaining a sense of the complexity of them trying to do all the things they did at the same time and in a hurry.)

140 Market as ideology The Special Investigation Commission of the Parliament A Special Investigation Commission (SIC) set up to investigate what the public authorities had done (or failed to do) during the years leading up to the collapse of the banking system in Iceland and the consequent hardships for the people of Iceland presented its report in 2010. A brief summary of its findings (Althingi 2010, Chapter 2) will provide a complementary perspective on the events. The primary reason for the collapse of the three banks, the commission says, is the rapid expansion beyond what their own management infrastructure could handle. Management and supervision could not keep up. From 2004 the growth in lending averaged 50% per year. The easy access to international credit markets, not least due to the EEA Agreement in 2005, was made possible by high credit ratings (with CBI seen as lender of last resort). The growth of the financial system in Iceland could not be matched by a growth in the capacity of the supervisory institutions. In one year, 2005, the three banks “got hold of around EUR 14 billion” – that is about the same amount as the GDP of Iceland – at favourable rates. The new government coalition agreed that the financial expansion should be encouraged to attract multinationals to establish business in Iceland. (Ireland might have been a role model, however consider the fate of the Anglo-Irish bank (Carswell 2011).) The SIC points out that in all the banks the largest owners were also among the largest borrowers. For Glitnir it was the Baugur Group hf. The SIC reports that in 2007 Glitnir had chosen a new Board of Directors, since Baugur had increased their ownership share in the bank significantly. At the collapse Glitnir’s exposure to Baugur was “a little less than EUR 2 billion equal to about 70% of the Glitnir equity”. In Kaupthing the largest shareholder was Exista that was also the second largest debtor – the largest one was Mr Robert Tchenguiz, a board member. When Landsbanki fell, the largest debtor was Bjørgolfur Thor Bjørgolfsson and affiliated companies. The owners of the banks were provided with facilities by the banks’ subsidiaries to invest in money market funds. As restrictions tightened in 2007 and 2008 the SIC argues that it seems to have become difficult to separate the interests of the largest owners from the interest of the banks. It is also clear that the largest debtors had debts in several of the banks. The capital ratios are suspicious since shares of the banks were taken as collateral for loans granted to the largest shareholders (to buy more shares). Furthermore, the banks invested in their own shares, and there was “crossfinancing” (the banks invested in each other’s shares – to keep share prices up). The shares of the biggest owners of the banks themselves were also found to be heavily leveraged. All this made the system as a whole very fragile. The supervisory agency (FME is the Icelandic acronym) granted the banks permission to engage in “the traditional activities of a commercial bank” during this period, which further increased risks. The FME should have demanded an

Market as ideology 141 increase in equity, but did not. (One might add that it should have required sound banking competence, but it did not.) The economic policy of the government – to increase long term growth – meant deficit spending by the State, which increased the imbalances of the economy. The change of the instructions to the public authority, the Housing Financing Fund in 2004 fuelled expansion by banks being allowed to underbid the traditional, mortgage terms. These expansionary policies of the government left the Central Bank (CBI) with only one weapon to fight inflation, raising the interest rate, which it was reluctant to do. When it did raise the rate it also provided liquidity to the financial system and part of this was against collateral in the form of the banks’ own securities. As a consequence of the inflow of capital to Iceland (in the form of international credits to the banks) the Icelandic krona was made artificially strong in spite of the fact that international liabilities were very large. The current account deficit of Iceland was large. When Danske Bank pointed out that the deficit was likely to grow further, the krona depreciated rapidly in 2006. All the requisites for an Icelandic financial crisis were already in place when the international crisis was set in motion in the summer of 2007. The banks now had several billions Euros due for payment in the second half of 2007 and further billions in 2008. To meet their obligations the banks resorted to raising deposits (at high interest) to improve funding. However, the initial success of the Landsbanki Icesave accounts (and Kaupthing Edge) in the UK turned into withdrawals during the fall of 2007. Still, during these critical six months, the banks increased lending to foreign parties by 120%. When the share prices of the banks started to fall, their value as collateral also went down, and the banks tried to compensate by engaging in buying their own shares (and lending to outsiders so they could buy their shares). In its search for who was responsible the SIC devotes a considerable part of the text to accounts of who talked to who and when. In statements to the commission, representatives of the government often claimed that the matter did not fall under their particular functional area. It seems like the administrators of governmental institutions were unaware of who was meant to carry out and take responsibility for certain aspects of these affairs. The commission was not expected to address possible criminal conduct of the directors of the banks. It was supposed to look into the activities of public bodies. The commission concluded that several ministers, including the Prime Minister and the Minister of Finance showed negligence, as did the representatives of the FME and the CBI. The business models of Kaupthing, Landsbanki and Glitnir It should be noted that all the big banks in Iceland came into being in their final form fairly late and with directives or support from the government. The supervisory State agencies could not keep up with the rapid expansion. It is

142 Market as ideology easy to imagine the surprise of the top managers of the new banks about how easy it was to get loans on the international markets (while they were being celebrated as heroes at home). The tradition was, after all, that in order to get loans you had to have connections – which actually was not that difficult in a country with 350,000 citizens. Expansion, expansion – provide credit lines to the acquired units and let them get on with it. There was no time to build a proper managerial infrastructure. When the imbalances of the Icelandic economy caused creditors to be restrictive, it turned out to be possible to get an inflow of cash in the form of deposits from abroad by setting up internet accounts with guarantees. The problem was that deposit holders are nervous people and when they started to withdraw – in what looked like an old-fashioned bank-run – all three banks fell, one after the other. Some of the managers are still being tried in court for criminal offences at the time this is written (as of 2018, 25 have been convicted). It seems like the business model of Kaupthing, as well as that of the other banks, was to manage the Balance Sheet rather than operations. When trust in the reliability of the figures was lost things unravelled quite quickly. The managerial capacity of all three Icelandic banks was clearly inadequate in view of the rapid expansion of business in all possible directions. It is difficult to understand, in retrospect, how managers could avoid seeing where their banks were heading. Did they hope to save some of the treasure for their own pockets before the ship was sinking? Reflecting on the role of the context, one might wonder to what extent this story has to do with banking in a small community where actors easily become captives in each other’s activities. Networking is strategic, yes, but it is also captivating, in a business, like banking, where the rhetoric is focused on the capability of “the market” to sort out any bad apple. A networked banking industry inside a “religious” belief system where personal responsibility is replaced by belief in an all-seeing market. The Icelandic banks are particular examples of organizations succumbing to a strategic stress syndrome.

Notes 1 I try to keep this introductory part on the philosophical “atmosphere” of Vienna as kaleidoscopic as it must have seemed to those who debated at the time. I believe this is an important background to the tension between planning/State and markets that provided the arguments on regulation that came later. 2 The impartial spectator procedure was discussed in Smith (1759) and tells the decision maker to consider how an impartial spectator would judge the contemplated act before acting (ethics). 3 I have decided to use MacLean as a source in spite of the apprehensions that follow naturally with this kind of condemnation, since I need a chronology and an account of the argumentative tactics that evolved with the proliferation of “think tanks”, spin doctors, and lobby organizations that constitute the relevant background to regulation efforts today. The reader is advised to consider reviews of this book and be aware. 4 This connection of Calhoun with Buchanan’s theoretical work is particularly offensive to Buchanan’s colleagues.

Market as ideology 143 5 The reader is referred to the home page of Montpelerin.org for further information; note on the first page that Stigler once quipped that the society really could be called “Friends of F.A. Hayek”.

References Akerlof, George A. & Robert J. Shiller (2015) Phishing for Phools. The Economics of Manipulation and Deception. Princeton: Princeton University Press Althingi Iceland (April 2010): Report of the Special Investigation Commission (SIC) Berle, Adolf & Gardiner Means (1932) The Modern Corporation and Private Property. New Brunswick: Transaction Publishers Brummer, Alex (2014) Bad Banks: Greed, Incompetence and the Next Global Crisis. London: Penguin Buchanan, James G. (1975) Limits to Liberty: Between Anarchy and Leviathan. Chicago: Chicago University Press Buchanan, James M. (1982) Better than Plowing and other Personal Essays. Chicago: Chicago University Press Buchanan, James M. & Niclos E. Devletoglou (1970) Academia in Anarchy: An Economic Diagnosis. New York: Basic Books Buchanan, James M. & Gordon Tullock (1962) The Calculus of Consent: Logical Foundations of Constitutional Democracy. Ann Arbor: University of Michigan Press Buchanan, James M. (1975) The Samaritan’s Dilemma, in (E. S. Phelps, ed.) Altruism, Morality and Economic Theory. New York: Russel Sage Foundation, pp. 71–85 Carswell, Simon (2011) Anglo Republic: Inside the Bank that Broke Ireland. Dublin: Penguin Clover, Charles (2016) Black Wind, White Snow: The Rise of Russia’s New Nationalism. New Haven: Yale University Press Cowen, Tayler (2013) The Average is Over: Powering America beyond the Great Stagnation. New York: Dutton Fallon, Ivan (2015) Black Horse Ride: The Inside Story of Lloyds and the Banking Crisis. London: Robson Press FCA/PRA (2015) The Failure of HBOS plc (HBOS). A report by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) FCIC (Financial Crisis Inquiry Commission) (2011) The Financial Crisis Inquiry Report. New York: Public Affairs Feulner, Edwin J. (1999) Intellectual Pilgrims. The Fiftieth Anniversary of the Mont Pelerin Society. Washington, DC: Heritage Foundation Fraser, Ian (2014) Shredded: Inside RBS the Bank that Broke Britain. Edinburgh: Birlinn Friedman, Milton (1962) Capitalism and Freedom. Chicago: Chicago University Press Friedman, Milton & Rose Friedman (1980) Free to Choose: A Personal Statement. New York: Harcourt Grind, Kirsten (2012) The Lost Bank: The Story of Washington Mutual: The Biggest Bank Failure in America. New York: Simon & Schuster Haas, Peter (1992) Introduction: Epistemic Communities and International Policy Coordination. International Organization. Vol. 46, no 1, pp. 1–36 Haegeman, Marc (2004) Inventory of the General Meeting Files of the Mont Pèlerin Society (1947–1998). Ghent: Liberaal Archief Hayek, Friedrich von (1944) The Road to Serfdom. London: Routledge

144 Market as ideology Ireland, Paddy (2009) Financialization and Corporate Governance. Northern Ireland Legal Quarterly, 1–34 Hood, Christopher & Ruth Dixon (2015) A Government that Worked Better and Cost Less? Evaluating Three Decades of Reform and Change in UK Central Government. Oxford: Oxford University Press Janik, Allan & Stephen Toulmin (1973) Wittgenstein’s Vienna. New York: Simon & Schuster Jensen, Michael C. and William H. Meckling (1976) Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure. Journal of Financial Economics, no 3/4, pp. 305–360 Kerr, Ron & Sarah Robinson (2012) From Symbolic Violence to Economic Violence: The Globalization of the Scottish Banking Elite. Journal of Organization Studies. Vol. 33, no 2, pp. 247–266 MacLean, Nancy (2017) Democracy in Chains – The Deep History of the Radical Right’s Stealth Plan for America. London: Scribe Madrick, Jaff (2011) The Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present. New York: Vintage Books Mises, Ludwig von (1912/1953) Theory of Money and Credit. New Haven: Yale University Press Mises, Ludwig von (1920) Die Wirtschaftsrechnung im sozialistischen Gemeinwesen, Archiv für Sozialwissenschaften 47 (Economic Calculation) Neurath, Carolina (2012) Den stora bankhärvan – Finansparet Hagströmer och Qvibergs uppgång och fall. Stockholm: Norstedts Olson, Mancur (1965) The Logic of Collective Action: Public Goods and the Theory of Groups. Cambridge, MA: Harvard University Press Perman, Ray (2013) HUBRIS – How HBOS Wrecked the Best Bank in Britain. Edinburgh: Birlinn Piketty, Thomas (2014) Capital in the Twenty-First Century. Cambridge, MA: Harvard University Press Popper, Karl R. (1945) The Open Society and its Enemies. London: Routledge Schumpeter, Joseph (1954) The History of Economic Analysis. London: Allen & Unwin Smith, Adam (1759) The Theory of Moral Sentiments. Edinburgh: Millar Sorkin, Andrew Ross (2009) Too Big to Fail – Inside the Battle to Save Wall Street. New York: Penguin Streeck, Wolfgang & Philip C. Schmitter (eds) (1985) Private Interest Government: Beyond Market and State. Beverly Hills: Sage Wittgenstein, Ludwig (1953) Philosophical Investigations. London: Macmillan Wittgenstein, Ludwig (1921/1922) Logisch-Philosophische Abhandlung/Tractatus LogicoPhilosophicus. New York: Harcourt Brace Zoega, Gylfi (2008a) A Spending Spree. VOX CEPR’s Policy Portal (9 April) Zoega, Gylfi (2008b) Iceland Faces the Music. VOX CEPR’s Policy Portal (27 November)

5

Concluding remarks

In this chapter there is a summary with some points highlighted concerning the interaction between the three philosophies (scholasticism, mercantilism, neoliberalism) and the failures of the case banks. The “existential risk”, when bank managers realize that their bank is in jeopardy and drastic action to save it is required, is taken up to show that under such circumstances the rational analysis of facts presumed by standard economics is not very likely to be applied. Instead it is likely that managers, like everybody else, fall back on principles they believe to be the fundamental ones (and in line with current philosophy) The only thing that is certain in such situations is that the old, normal ways of managing do not work. One explanation, found in the literature of both the failure of the Sevillian banks and the Icelandic ones, was a too large inflow of money to the economy. Medici and Barings fell because of inadequate internal control. Fugger and RBS were victims of “hegemonic power”, one from the Habsburg court, the other from an overambitious (and arrogant) top manager. It seems like “political power” could be looked upon as a currency. What about the future? It seems like we are entering a period of “warring professions” trying to manage our thinking about money and banks as well as about democracy.

5:1 Summary with highlights The justification for studying failed banks has been to get hold of the “existential risk”; the problem of understanding what preceded failure – when managers realize that there is a present and dangerous risk that they will lose control and be separated from the right to manage the organization in focus. This is, obviously, a risk that is different in kind from all the other risks we connect with banks (currency risk etc.). When existential risk becomes a reality in the mind of managers, they will probably initiate radical action to save the organization, and continue to have the mandate to control it. They might of course resign and leave the problems to others, but that would be embarrassing. What is certain is that in such a crisis uncertainty is maximal. What then? How do they construct action from mere overwhelming uncertainty? And how do they explain to themselves how they came to be in such a situation? This is the reason for studying failure.

146 Concluding remarks In this first part of the chapter I try to bring up and comment on the main aspects of the earlier chapters to find bases for conclusions. In the latter part I will reflect on the findings and try to provide a theoretical frame in which existential risk can be embedded. 5:1:1 Scholastic times The three cases of pre-modern bank failures were chosen because they were relatively well documented, they were role models of their time, perhaps mostly because the banks were remarkably successful for an extended period – more so than present day banks. They lived when the social order philosophy was stable, based in scholasticism and the church’s far-reaching organization to supervise compliance with its teachings. This does not mean that times were tranquil and conducive to the pursuit of the arts and crafts. On the contrary, princes were warring for conquest, plagues raged, and highwaymen and pirates threatened every transport. Life expectancy was limited, and you were well advised to concern yourself with the afterlife. How can I assure that my soul reaches Paradise? The church had answers: by living a pious life, working hard, giving alms, and knowing your station (and paying your dues to the church). Then the saints would help by pushing the demons aside. For the rich it was charity, donations to the church, and burial in or close to the church, where the saints were ready to clear the way. These beliefs provided scholasticism with the authority to serve as a reference in justifying action in society (and in banks). The justification problem for banks was how to argue that a certain business deal did not include usury. In time certain modes of doing banking become accepted as proper and progress is made. Some constructions are condemned by the church and/or, its representatives, and need to be modified or abandoned. When a certain mode of banking becomes a practice that is considered problematic from a scholastic point of view, scholars will go to work analysing the different aspects of this newly discovered practice. After a debate a general scholastic opinion on this matter will settle and the scholastic dogma will have changed, and justifications (if not practices) will change accordingly. The other source of input to changes in banking practice were shocks or other changes in business contexts. The most ominous was war, which was conducted on credit with princes often forcing bankers to provide credit against a promise to repay, or by mortgaging property (like mines, or tax collection). Wars also tended to close trade routes and block sources of raw material. Successful wars tended to encourage the prince to demand extended credits for further conquest. Lost wars would leave the prince unable to pay. That is why the Medici Bank under Cosimo had the policy not to allow credits to princes (there were exceptions, of course). Trade routes changed, for instance when the flow of spices etc. from the East to Venice was blocked by the Sultan, or when the king of France promoted Lyon as the new market place for silk, requiring merchants/banks to set up a branch to be able to participate (and cash

Concluding remarks 147 Bills of Exchange) there. The merchant bank had to attend to the ebbs and flows of conditions in this way. All business is local even if goods come from afar. This also means that there is a real managerial problem supervising the local branches in a network like the Medici one. Internal cheating and disregard of company policy were contributing causes to the closure of Medici banking. However, banking is conducted in cities, where there are other banks and a city administration that is reliable. Free cities were interesting from a banking point of view since they were creditworthy – citizens were personally responsible for the debt of the city council. So, such cities would have a stable administration with the leading families competing for positions. They would also harbour the seeds of an emerging bourgeoisie. The trades and crafts were regulated for entry and conduct. Guilds also constituted a context where business could be promoted. The Fugger family was able to establish itself in a leading role in the guild of the textile/tailoring business in Augsburg. Thus it was in a position to become involved in deliveries to the court (provided it could import the best silk from Venice). The Fuggers also established a family bond with the manager of the Mint, and in that way could learn about mining and, further, provide credit with mining contracts as collateral; two ways to get the Habsburgs as clients. Knowledge about mining would come in handy when Spain (under Habsburg) built colonies in America to bring in silver and gold to Seville. Fugger, unlike Medici, became a “court bank”. In the end it seems Medici could not resist the local temptations of meeting the “right people” in the grand rooms of palaces. (There is, indeed, a strange relation between power and finance throughout this tale of bank failures!). Fugger tied itself to the power centre of the world with strict loyalty to the main customer, and to religion. The action in cities, seen from a banking perspective, was beneficial in that it generated secondary markets for commercial papers. The proximity of other banks around the main square in Bruges, or on Lombard Street in London, could uphold a beneficial liquidity (if you had “a good name”), and the banks could participate in financing the City Council and its projects. This proximity also made it possible to copy innovations quickly. Competitive advantage was won by connections. The Seville banks were overjoyed as silver and gold started to come in by the shipload to be deposited in their vaults for safe keeping. Precious metals were primarily a private business for the aristocracy. The King took 25% of the landed treasure to the Mint, the rest, unfortunately, tended to be withdrawn by the owners. Preferring a quiet life at the hacienda, aristocrats took on the habit of lending money to the King and living off the interest – becoming rentiers rather than entrepreneurs investing in long term development of the Spanish economy. Remarkably, the decline of Spain started with the inflow of precious metals. The public banks in Spain, that were fairly small in comparison with the “court banks”, were truly merchant banks in the sense that they sought diverse

148 Concluding remarks sources of income. This led them to invest in long term projects, like ships (or loans to the King), which made them vulnerable to short term variations in the flow of funds, for example when the King declared the State bankrupt, or rather postponed servicing its debt in 1575, or when the treasure fleet was delayed. The impression is that a business model oriented toward diversification of revenue sources placed these banks under stress when the credit expansion stemming from the flow of precious metals unsettled the Spanish economy. The fact that the four banks of Seville fell together over a short period of time reminds us of Iceland. They had become captives of their context. 5:1:2 Transition – science and mercantilism Critiques have pointed out that mercantilism does not belong among the ideational backgrounds, like scholasticism or neo-liberalism, that provide bases for justification of bank action. True that it is not an “academic” theory like many others, but a movement driven from about 1620 by “Administration consultants and Pamphleteers” to use the label given by Schumpeter (1954). But it did provide an ostensible ideology, especially when combined with the emergence of science, and rational planning by a State, focused on the costs and revenues of the State. The changeover from scholasticism to modernism did not happen over-night. Skilful administrators like Jean-Baptiste Colbert, Johan de Wit, Robert Walpole played a crucial role, even if they, at times, were overridden by those with Divine Power. It took wars, scientific breakthroughs, and nascent colonialism to keep it moving. McCloskey (2006, 2010, 2016) argues that this was the time that the bourgeoisie found its dignity and equality. No longer were people convinced that they were born to a certain station in society, but rather that they could control their own destiny. Along with the scientific discoveries came engineering geniuses and entrepreneurs. Capitalism of the laissez-faire variety emerged and finance moved to London – the centre of the world. These were the golden days of merchant banks with their small organizations and networks reaching far into the colonies as well as inside Parliament. 5:1:3 Barings Bank through mercantilism and laissez-faire (to confront a “rogue trader”) Barings made itself a name as a conservative bank oriented toward “relational” banking. It had excellent connections especially in the USA where it assisted in financing the Louisiana Purchase and participated in the railway bonanza. Bad investment decisions and subsequent liquidity problems made the family lose control for a while in 1890. The Bank of England organized a rescue package that forced Edward Baring to resign and left the family with only 20% of the equity. The lesson learnt, and control regained, the bank came out of this as an even more conservative actor with a focus on not losing control again. Barings managed through two world wars as a small, but well connected, merchant

Concluding remarks 149 bank. The new situation after the Second World War, with sovereign debt management, rebuilding of a damaged economy etc., provided Barings with the choice to withdraw, more or less, to the domestic market. When deregulation (to meet the overwhelming challenge from the New York financial industry) and globalization (via new technologies, like IT) again provided a basket of strategic choices Barings seemed to be stressed (strategically) by its earlier set priority to keep control within the family, in combination with the need to grow in order to avoid becoming a “target” for predatory capital. The compromise of hiring a team of agile traders in the Far East (without the traditional loyalty to the firm and its owners) set the stage for a tragic internal case of treason (Nick Leeson) from which Barings could not recover. Little does it help to remind ourselves that owner control of large companies had been questioned already by Berle & Means (1932), and Chandler (1962, 1977) had argued that a new class of professional managers had taken over. Focus on family control should have been replaced by a focus on systems control, and Barings would not have given Leeson the opportunity to audit himself. A product of neo-liberalism, Leeson did not feel any particular loyalty or responsibility toward Barings Bank; if he did it was embedded in a confident belief that he could sort things out and regain what was lost, if he was only given time. 5:1:4 Defending the market economy 5:1:4:1 Ideological mobilization The transition, from scholastic interpretation of sacred texts in order to apply their principles to concrete situations, to a liberal laissez-faire capitalism had brought economic growth and prosperity to the bourgeoisie (McCloskey 2016), but it also brought devastating wars and the ideas of socialism and a redistributing Welfare State. Already after the First World War academics, and other intellectuals in Vienna, had taken up the challenge from the left and the Soviet Union, who argued for “collectivist” solutions. The economists, who participated in the debate (Austrian School) argued for market-based solutions and a new German-speaking Austria. (They were closely involved in the design of a new Austria after the world war.) But, the Liberal experiment of the Weimar Republic and the rise of Hitler, demonstrated that markets do not solve problems by themselves. The Weimar debacle, and the extremely tight regulations in place after the Second Word War posed very complex policy problems. Science could help, academics thought, with recommendations on how to secure well-functioning markets and avoid repeating the Weimar experience. One of the central figures, activist Friedrich von Hayek, took the initiative immediately after the Second World War to organize liberal policy thinking and channel it to governments, by calling friends to what came to be the Mont Pélerin Society with annual meetings to discuss current policy issues and

150 Concluding remarks scientific progress. This became the core of neo-liberalism with its economic theory centre at the Chicago University. Not far from Washington, at George Mason University, another activist centre grew in importance by its focus on educating firebrand neo-liberals for a career in the courts and administration. It was well funded by a number of foundations pledged to promote freedom and markets. Primus among the principals of these foundations was Charles Koch (and his brother), who wanted to reduce the reach of State administration to a minimum. This centre of Libertarianism found its theoretical justification in Buchanan’s Public Choice Theory (bureaucrats (and politicians) serve their self-interest and are likely to be corrupted by “special interests”). But, in time, Buchanan found himself out of control of the agenda and was pushed aside by lobby-experts looking for a revolution to hijack (as the Bolsheviks had done). They found one (a revolution) in the globalization cum de-regulation that generated discontent over lost jobs in the “rust belt”; and a finance sector that could turn risk into gold without fault. Populism combined with laissez-faire market liberalism is difficult to uphold logically as a unified message. But new data mining techniques allowed the “spin doctors” of the movement to “profile” recipient groups and send adapted messages to please each group, never mind the contradictions. In this way power could be maintained by “managed democracy” and the minority could be protected from abuse by the majority. Political power, influence in court appointments, and a crusading administration in several countries allowed the financial sector to grow to assume an impressive part of the GDP. That a significant part of this financial GDP growth was generated by a proliferation of financial instruments valued at “market values” in financial reports of banks as well as “shadow banks” was no one’s concern. We had all learned that the market always sets the right value of an asset (when it is in equilibrium). When Piketty (2014) pointed out that the consequence was not that wealth was “seeping down” to the poor, but instead huge amounts of wealth were transferred to the elite (from the poor), he was criticised for poor methodology. (Scholasticism again?) These ideologies were seemingly more organized and activist in their aim to impact policy orientations of governments and international bodies. It was Thatcher and Reagan who adopted these policies that changed the rules of the game for finance. The academic contributions came in the form of mathematical models for calculating prices of financial instruments under various assumptions of market conditions (like Black & Scholes 1973), and ideas about a lack of loyalty (ethics) in organizations (like Jensen & Meckling 1976). These academic contributions allowed pricing of assets on the basis of speculation about future cash flows (earlier accounting for values according to rules must follow the realization principle – that the value of an asset had in fact been “realized” by being bought or sold by a third party), which could be used to inflate the asset side of the balance sheet. Note that the asset side of banks consists of loans! The agency theory (Jensen & Meckling 1976) introduced the idea that members of the organization, acting as the owner’s agent, are likely to

Concluding remarks 151 deceive the owners (since they have better information). The only way to control these misbehaving employees was, obviously, by economic incentives (like bonuses related to performance, particularly share price) since they are only driven by self-interest. These assumptions are very easy to “reify” – since if I now know that everybody is doing it, I might as well join the race. The owners, principals in agency theory, have rather modest desires, but they have their rights to do whatever they wish with the firm in the form of “property rights”. They rather look like the Philosopher Kings in Plato’s Republic some 2,000 years earlier. If this liberated financial capital finds it opportune to sell out the firm they control in parcels in order to enhance share-holder value they will do so, and justify it by referring to market arguments. Attention had been shifted by theory, from the calculating entrepreneur seeking the best solution for the firm, to the calculating investor seeking the best deal for himself. In the practical policy arena de-regulation started with the Soviet Union withdrawing money from its American accounts (petro-dollars) and depositing it in Paris because they felt unsafe in the intensifying Cold War. This fed a European financial market and Thatcher saw a chance to improve the competitive position of London (against the evermore dominating New York) by, eventually, the Big Bang – a broad based de-regulation of the financial sector to make London an attractive place to be for bank people. De-regulation was justified by the arguments provided by neo-liberalism – markets will improve solutions and efficiency. By the way, this also applies to the public sector (Buchanan 1975). The problem with this new freedom was that the number of strategic options that offered themselves were innumerable, and the future consequences of each choice was impossible to fathom. This was not a major problem, though, since market corrections (down-turns) will generate winners as well as losers. New professions (modellers (“rocket scientists”), risk managers, IT-specialists) entered the banks with assuring claims about the capacity of calculative practices to deal with the uncertainties by calling them risks. One thing was certain, though, if we do not grow by acquisition and internationalization, we are likely to “come in play”, i.e., be subject to take over efforts by other actors. That would mean loss of control – the ultimate existential risk. There were mutually supporting strands in the new ideology, academic research output, as well as practical policy, to generate a bubble of gigantic and all-encompassing dimensions. There was easy money to be had in credit markets stimulated by increasing money supplies and relaxed capital requirements for banks, and asset values that soared. It was in such circumstances that the two case banks I have chosen were supposed to find their way. 5:1:5 Victims of the market revolution Royal Bank of Scotland (RBS) had old roots and a long-lasting rivalry with Bank of Scotland (“the old bank”) for the top position in Scotland. There was

152 Concluding remarks an understanding that English banks did not enter Scotland and vice versa. With the new signals of de-regulation, the rules of the game had changed. Mathewson was hired to introduce new management strategies. He initiated top-down reforms and strategic (defensive) acquisitions. He also hired Fred Goodwin, who turned out to be even more authoritarian than Mathewson and out-manoeuvred him to gain hegemonic power by bullying subordinates. RBS surfed on the upswing, as the darling of the stock exchange. (Its value was greater than all other Scottish firms together – an efficient market in operation?). The acquisition of ABN AMRO was an overconfident mistake that started the decline and showed that even Goodwin himself could be “out-manoeuvred”. This case illustrates the corruption of reason that follows from power games within organizations dominated by confident members. It seems fair to say that Goodwin managed to surround himself with people who would accept decisions without (open) questions. Mathewson, himself an authoritarian, chose to withdraw where he should have taken a stand to challenge Goodwin by demanding proper justifications for different initiatives. This case is about power becoming the currency in vogue. The second case, about the Icelandic banks illustrates how three banks became captives of their own success. We now know that at least managers in, and around, the banks committed crimes in their glaring enrichment of themselves. One could have guessed that the smallness of the Icelandic society would provide a community-like oversight that would have reminded the main actors of basic ethical principles, but in this case the managers were able to seduce society as well and remain heroes up to the collapse. The three big banks in Iceland were new creations initiated or supported by the State. Iceland entered the new financial era with de-regulated international markets and new European agreements. Surprised by how easy it was to get large credits at low interest (compared to what was common in the earlier inflation-ridden economy) the optimism of central actors bloomed. Credit ratings were great (and improving), and the success of the initial projects to acquire actors in the Scandinavian markets generated an appetite for more. Control from the centre was minimal and this was presented as a conscious, strategic choice. The State applauded and enjoyed the growth reports as the credit boom supported a proliferation of promising projects. Lax control provided ample opportunities for members to enrich themselves in accordance with the neo-liberal doctrine (as if they were agents and principals at the same time). There is much to be learned from the Icelandic case due to the fact that society is small and (usually) transparent. Is it reasonable to assume that moral aspects of banking are nurtured locally, while reckless risk-taking is nurtured at a fascinating distance? Distant actors were aroused a few years into the new millennium when international analysts noted the imbalances of the economy and questioned the ability of the State/Bank of Iceland to serve its function as lender of last resort should this rapid growth continue. The brilliant idea to replace money from a hesitating credit market with net-based deposits with competitive interest rates

Concluding remarks 153 turned out to be not so brilliant when depositors started to withdraw funds as warnings were voiced. The State could not help when things turned sour (after all the country had 350,000 inhabitants) and the banks failed one after the other in a tight sequence. The Special Investigation Commission report brings up an interesting dimension in its analysis of the Icelandic case (they name several culprits), namely the power of banks and how they may lose it. In normal times they can very much dictate conditions for loans, but if the borrower is already in large debt and the bank is, therefore, already at great risk, the relation may turn to the disadvantage of the bank. If the borrower should default on current loans the loss would be even worse. The new loan had to be granted. The bank becomes a captive of its customer. It seems natural to extend this captivity dimension further to the State, as well as to regulatory authorities, and rating institutes, when the banks have outgrown the State, as in the case of Iceland. (Ireland may provide another similar example.)The theoretical implications of this phenomenon should be kept in mind when we look further into the space of action at the very onset of a crisis .

5:2 Commonalities and differences between victims of circumstances It is perhaps inappropriate to call the failed banks presented above “victims of circumstances”, but the focus here is on how management in these cases responded to “circumstances”. Such response can, obviously, be more or less well adapted to solve the problems at hand. The idea behind this whole project is that the ideational context and the creative solution of practical business interact to generate “regulation regimes”, each with its distinct logic, and rhetoric. The work of Streeck & Schmitter (1985) was chosen to frame the dimension of such “regimes”. They use Community (spontaneous solidarity), State (hierarchical control), and Market (dispersed competition) to form a triangular space within which current bank practices (or accounting ones) are moulded. One can imagine current bank practices being pushed, to and fro, inside the triangle by arguments and new practices stemming from the different corners. There is no total domination (note: hegemony) by either of the three “corners”, but it seems fair to say that at the time of the first three cases (Medici, Fugger, and Seville) it was Community that held the upper hand, while State in the form of an interventionist Prince and emerging bureaucracy was gaining influence with arguments coming from mercantilism. Market had little to do with practices and justifications at the time (500 years ago) since business was mostly done in the form of deals between individuals. “Market Power” followed from being well connected and having a “Good Name”. It was only later in the period that conceptions of markets (and prices as “common estimates” of prices) came into use as justifications. The business model of the individual bank is assumed to serve as a sorting device to judge all impressions coming to the attention of management, for

154 Concluding remarks relevance and relative importance – and for constructing justified action. This means that each bank is assumed to have its own specific “persona” inside the current constitution of a regulation regime. Comparison between banks, therefore, must be done with caution. 1

2

3

One striking similarity between the Seville and Iceland banks is that the problems are described as depending on a large “inflow of money” in both cases leading to a credit expansion and subsequent imbalance of the economy, which may be assumed to have stimulated recklessness on the part of the banks. There the similarities end; Seville suffered from a strong interventionist king, while the Icelandic banks were too large for the government to be able to interfere or come to rescue. We can, however, conclude that in both cases “events” struck with overwhelming force. The banks had lost their ability to fend for themselves (certainly by earlier imprudent action). It might be of interest to discuss to what extent and when these banks became captives of “events”. They, indeed, had few options to choose from toward the end. The Medici and Baring cases are similar in the sense that they were victims of a combination of internal “foul play” and inadequate central attention and control. In the Medici case the “head office”, after Cosimo, increasingly had its attention directed to things other than banking, while (incentivized) managers of branches made deals that were unauthorized from the centre. Barings bank had weakened central control capabilities by defensive acquisitions without a matching control infrastructure, especially concerning advanced IT system use. This provided Leeson with an opportunity to hide his (unfortunate?) losses while trying to recoup them by taking even greater risks. In sum, these two banks were not equipped to control for internal treachery. There were internal “events” that went too far to remedy. Both banks had to dismantle their business. The Fugger and RBS cases are similar in the sense that they fell victim to “hegemonic” power. In the Fugger case, by the close ties to the Habsburg dynasty and its costly wars (on credit), and in the RBS case by providing one manager, who could do nothing wrong, with virtually unlimited power. Power becomes quite visible in these cases. “Power games” invite thoughts about power as a kind of currency.

This leaves us with at least three types of managerial problems with bank management. a b c

Significant external events that change the “rules of the game” Internal misbehaviour that is not matched by central corrective capability Political power over-ruling managerial reason

One can, of course, blame external factors for one’s misfortunes (like, for example, attribution theory in psychology teaches us), but one can also look at

Concluding remarks 155 the world from a perspective indicating that it is the task of management to act with such prudence that the misfortunes can be avoided or managed. In earlier research (Jönsson & Lundin 1977; Hedberg & Jönsson 1977; Hedberg & Jönsson 1978; Jönsson, et al. 1977) we have focused on organizations in crisis, and what signifies the turn-around when the organization overcomes its predicament. We found, in case studies, that with management focused on the environment as the source of causes for the decline (which is the standard position in normal, planning times) there were tendencies toward paralysis in facing overwhelming external forces in the form of complexity (this we called environmental attribution – think of an animal starring at the headlights of the approaching car at night), while in the upturn after the crisis, large parts of the organization membership were in “ego attribution”. This means that focus in explaining current events as well as in allocating responsibility for outcomes is on “us”. It is up to “us”, “we can do this”, “we know what is wrong and we now know what to do about it”. This shift – in crisis organizations – from attributing causes of events to the environment, to seeing ourselves as cause of progress – is a core task for bank managers to achieve. Banks, as we know, are subject to cycles of crisis (most often articulated in credit impairment) and they therefore need to be able to shift between these two attributions, and, thereby, direct the attention of their members toward the right thing. The three types of causes listed above (as a, b, c,) could perhaps be dealt with – at least in a research framework – if we realise that attribution has effects on judgement concerning relevance, causalities, as well as the construction and communication of appropriate action. Then we could progress beyond markets and risk modelling and come to grips with bank management, which is a particular type of management, as I hope I have shown. Looking back at the Medici and Barings cases we can see that there is a lack of a firm hand at the centre, which can access and interpret local data about activities. In Medici it was branch offices and their different deals that went out of control. In Barings it was internal control of what was entered into the advanced, and somewhat overwhelming IT-system. In Barings this combined with the new kind of professionalism under incentive systems – and a capacity deficiency due to the strategic preoccupations of top management (strategy stress syndrome). So much the worse, as Leeson, seemingly, was allowed to audit himself (Soll 2014). For the Seville and Iceland cases external forces were obviously overwhelming once the situation emerged, however the joy of the “overwhelming” inflow of resources that preceded the crashes should have evoked some concern. Hedberg & Jönsson (1978) advise that when everything seems to go splendidly one should appoint a committee to find out what is wrong. One wonders what could have happened if the Icelandic banks had appointed a forceful pessimist to whisper “memento mori” now and then. The RBS and Fugger cases are of particular interest here since they seem to illustrate the dangers that follow from overuse of power (rather than reason) in

156 Concluding remarks financial management. Fugger sought and was very successful in tying itself to a particular, powerful centre. This was tempting because it offered many opportunities to gain by providing un-questioning service to the powerful client. But, when adversity afflicts such a centre, the consequences are indeed overwhelming and virtually un-manageable. In the RBS case the centre of power was internal. When Mathewson gave up his role as a balancing moment from the board position, that internal power lost the “Check and Balance” it needed. It was only a matter of time before the failure in an ultimate, grand project would happen. For the individual member of a management team in such circumstances, the need to leave in order to preserve one’s integrity is obscured by all the pleasures such a “hegemon” can offer in celebration of success and loyalty. All the arguments above illustrate different aspects of how perspectives are narrowed down in “normal” times, and action is delayed when crises are approaching. This is an especially difficult challenge in banks that very much depend on the prudence of their clients.

5:3 The supportive role of the Community/State/Market triangle At the very beginning of this text (section 1:1) I pointed to the three schemas of social order that Streeck & Schmitter (1985) have presented and discussed in many texts. My idea is that social philosophies and current practices merge into some kind of regulation of proper conduct. This disciplining force, in the case of banks – which are different between themselves, and which, in turn, can be summarised in their specific business model – colours how action is constructed (internally), and justified (externally). Changes in the dominating philosophy about the good society as well as changes in banking practices (for example, due to the introduction of new technology, like IT) will “push” the regulatory “centre of gravity” toward one corner or another. The issue to discuss here, then, is whether this framework helps in organizing the multidimensional information that case studies of philosophies, practices and individual banks provide. Here I will give an account of my interpretation of the “movement” of the bank practices under the influence of the shifting regulation ideologies they were subject to over time. We started with merchant banking under scholasticism. This philosophy is quite clearly a strong influence of Community (spontaneous solidarity) as the church serves as an “enforcer” of the teachings of the church fathers and texts produced at centres of learning. (“Don’t do usury!” is a difficult principle to dodge for a bank!) The church is well organized for this task with clergy interpreting divine law under local conditions in their parish (and asking bishops, or centres of learning for guidance on complex issues). By this local oversight and hierarchical information flow on emerging issues the church was, indeed, well organized to assume the guardianship of social order. The merchants under this regime were organized into guilds (a community) that controlled entry and conduct. Still, their daily practices generated ideas on how to

Concluding remarks 157 perform services better, not least how to accomplish payments in a safe way avoiding the perils of transport of coin. Further, the trade between market towns yielded opportunities to benefit from arbitrage on exchange rates. Merchants would set up branches at various destinations, where they also could benefit from the liquidity of secondary markets for trade credits. Proximity, and appreciation of the value of a “good name”, and connections, are attributes of Community. Professionalism is expressed by living up to the standards of guild membership. The movement away from the total domination of Community came with the habit of conducting large scale war on credit. This was nothing new in itself, but whereas ancient armies provided for themselves by plunder, the conquering princes of the 15th century and onwards wanted the new land to be administered for taxation and prosperity. This desire for a “rule of law” presupposed that plundering soldiers were kept away or dismissed once the postvictory order was established. Mercenary soldiers were, thereby, handed the blackmail weapon of plunder if they did not get their pay (sold) on time. The issue of order and protection of citizens becomes a twin concern with warfare on credit. Important players in this development were the free cities that had been granted privileges by the king in the form of tax collection and the right to finance municipal activities by loans. Furthermore, the creditworthiness of a city hinged on the individual responsibility of citizens to guarantee the city’s loans. In Amsterdam the right to vote on city matters came to be tied to the ownership of prescribed Kapital (hence Kapitalism (see Greenfield 2001)). The welfare of the (free) city was dependent upon its creditworthiness, which was, in turn, dependent on the guarantee for city debt that citizens constituted – if the city could not pay the claimant had recourse to the citizens. This feature of cities made them interesting subjects of negotiation in the financing of war as well as in the provision of bank services. The bourgeoisie becomes visible also to princes. The multiplicity of tasks related to financing, the keeping of peace, and rule of law give rise to bureaucracies and a need for educated civil servants. The State was emerging as a hierarchy of competent administrators with entitlement to regulate the social order. Universities, with faculties of Law and Theology, run by monks, provided educated candidates for positions in central government. Mercantilism was an articulation of the need to control the flow of resources in and out of the nation so as to achieve welfare for all and avoid unfair competition from abroad. The arguments were presented by “Consultant Administrators and Pamphleteers” (Schumpeter 1954). The imbalances of the economy were intolerable by 1650; something needed to be done. A necessary requirement for such hierarchical control was reliable accounts of flows (taxes, imports, exports), statistics on inhabitants, production, consumption, tax revenues, debt management etc., and a well-educated cadre of civil servants. Trade took on new dimensions with the discovery of the Americas (El Dorado). The exploitation of the new continent needed to be organized properly, and the chosen form was to grant trading companies like the East-India

158 Concluding remarks State Mercantilism

Medici, Fugger, Seville Market

Community

Figure 5.1 Mercantilism pushed regulation from Community to State

company or the South Sea Company privileges to run certain aspects of it. Mercantilism favoured importing raw material and precious metals, but it also argued for investment in manufacturing at home to build capacities to add value to imports and export manufactured goods at higher prices. Spain neglected this kind of capacity build-up, pre-occupied as the Habsburgs were with warfare on credit (crowding-out such investment by the very rich importers of silver and gold, who preferred life on the hacienda with annual rents from the King’s treasury). The problem with the exploitation of the new colonies from a strictly Spanish perspective was that much of the trading house activities migrated to Holland and, in time, were more or less lost by the Spanish court. Holland then lost out to England in the struggle to “rule-the-waves” and banking came to be best conducted from London headquarters. Building a manufacturing capacity to transform all the raw materials coming in to expensive “manufactured” goods required merchant banks in a role to help distribute funds from the rich to the entrepreneurs with good ideas to realize. One should note that organizations like the East India Company were very large organizations, while merchant banks, now engaging in a host of new kinds of financing operations, were small. Being stretched for management resources, merchant banks abandoned the actual trade and focused on financial services. For example, the financing of the building of railroads required large issues of financial instruments. Nationalist governments needed new loans, etc. This was the golden age of merchant banks, and the bourgeoisie prospered in the new entrepreneurial spirit, with inventions and new engineering solutions everywhere. New infrastructures to make it all possible were put in place (McCloskey 2006, 2010, 2016). England’s economic domination peaked. Then came the wars. The First World War, on top of the devastating loss of life, saw a Russian revolution growing out of the horrors of war only to be taken over by the Bolsheviks, who were set on going international. The Great Depression of the early 1930s set the stage for further efforts by the State in many countries to get the economies going again, only to find themselves in the Second World War, which required further mobilization of national resources under hierarchical control. The post-war period had to start

Concluding remarks 159 with further regulation of everything, and the Marshall-plan to rebuild Europe. There were strong arguments for Welfare State solutions and strong arguments for market-based solutions. Economists found themselves required to mobilize efforts for promoting policy recommendations. This took place in 1947 (at Mont Pélerin) on Hayek’s initiative. He was, as I have shown, a jurist and an economist with significant experience of how to design a new State after a devastating war and strong convictions about economic policy. This was no time for isolation in academic quarrels. One had to reach out to politicians to secure economic development and avoid yet another war. Collectivist solutions (governments) ran the risk, again, of being “hijacked” by Bolshevik-like groupings. Individual freedom, free markets, a free press, and reductions in the current omnipresence of governmental regulation, were necessary parts of a viable solution. Friedman had the arguments to back it up. Neoliberalism and Libertarianism were an organized, activist offensive. The Cold War was a reality, Europe was building a union to prevent another war and promote crossborder trade. The world was becoming more complex (and “globalized”). New techniques in economic modelling and computing power made it possible to simulate future consequences of policy choices. Policy oriented economic research (and “institutes”) had a comeback and resources tended to concentrate in centres of learning in the USA, where the world financial centre had been established in New York. The UK and London made a heroic effort to re-establish themselves in a leading role with the Big Bang, but the action had moved across the Atlantic for good. London gradually was demoted to a subsidiary role. The Market as the basis for social order (“dispersed competition”) could not be designed by the State, just made possible by de-regulation. The arguments for reform had been established, now the financial world was set free to make it real. On the road to a world of free markets, many banks could not keep up with all the changes. They fell on the wayside, which in many cases meant being saved by the State. The case banks that fell victims in the rush to market freedom, Barings, RBS, and the Icelandic banks, all seem to have suffered varieties of strategic stress syndrome – when management capacity does not match the variety of options and the uncertainty of the information surrounding them. In the case of Barings, it was the incompatibility of retaining control in the family while building defences against take-overs by acquisition. The compromise solution made Barings open to internal fraud by manipulation of the “integrated” information system. An “integrated” information system is a system where most links between different parts are automated by algorthms – knowledgeable operators can manipulate by (temporary) interventions in those algorithms. The fraud was obviously driven by the explosion of incentive systems that had been implemented throughout the financial world (instead of management). The market ideology had ushered in the related idea (i.e., agency theory) of incentives controlling the individual, something that, as it turned out, could not compensate for management oversight.

160 Concluding remarks In the case of RBS, the “solution” to the stress of competing in a de-regulated environment was to bring in “strong” leaders – managers who could infuse the organization with courage and action energy – first Mathewson and then Goodwin. Part of the establishment of “strong leadership” is to eliminate internal opposition and dialogue, but it also feeds on successful, daring projects. The tripping stone for Goodwin, when the ABN AMRO acquisition did not turn out as he had expected, was his pride (not to try to re-negotiate the deal between the three partners when the La Salle bank in Chicago was no longer part of the deal. An outside observer cannot be sure that this did not take place, but we have no evidence that it did.). Noteworthy here is that the de-regulation of the financial sector seems to shift attention to acquisitions (and holding gains) as the primary means to success, rather than good bank management. There were “innovations” in the product market and technology of finance, of course, but the enthusiasm over the incentives to be gained by selling (subprime) products overwhelmed prudent management. The Icelandic banks were newcomers to the international financial markets and they were surprised by the ease with which one could muster credits there. The reason seems to have been that an optimistic international market treated these banks as any other banks with the backing of rating institutes, and a lender of last resort. These banks were “system critical” all right, but to assume that a central bank, backed up by 350,000 (equivalent to one of London’s suburbs) inhabitants/taxpayers would be able to bail out the banks, should any of them fail, is beyond reason. It should be noted that no Scandinavian bank seems to have lost money on Iceland. One Swedish bank manager interviewed in this project said “I could not understand how they were making their money, so I sounded the alarm!” It seems like similar reactions from the other Scandinavian banks made them withdraw in time before the crash. The management of the Icelandic banks lacked a tradition of large bank management that could have alerted them to the possibility that the success of their projects was due to the upsurge of the bubble rather than their own skills. The Icelandic banks never managed to reach the “advanced” level of capital protection in accordance with the Basel II regulation. Such advanced level risk management presupposed that the bank had installed a risk management system based on internal rating of individual credits. Had they been able to do that, they would have been allowed to increase leverage still more, and the fall would have been worse. The fact that Scandinavian banks avoided large losses on Iceland is, no doubt, due to their access to “local” information about what was going on – goings on that would not be captured in risk management models of far-away banks.

5:4 Reflections on banks and their environments Banks are different because they work in different environments, and they are managed by different managers with different business models. Regulation based on universal conceptions of what banking is (and how markets work)

Concluding remarks 161 STATE “Hierarchical Control”

“Theory/Debate”/ Principles

“Theory/Debate”

Practices Principles

MARKET

COMMUNITY

“Dispersed competition”

“Spontaneous Solidarity”

“Neo-liberalism”

RBS

“Libertarianism”

Icelandic banks

Figure 5.2 The market did not save RBS and the Icelandic banks

will favour some and punish others since banks are different, and they strive to be different. One might hope that those who were punished were those who should be eliminated – a Darwinian thought closely related to market liberalism (remember Schumpeter’s “creative destruction”). On the other hand, if RBS had chosen a CEO with more bank experience and less self-confidence, that bank would be in a different position today. However, one cannot be sure; looking at the main competitor at the beginning of the case, Bank of Scotland (BOS), we can see that its fate, as it was taken over by Halifax to form HBOS (Perman 2013), is not much better. The Icelandic banks were doomed by their size in relation to a small country with limited resources (and by amateurish management). Their fate, as the Special Investigation Committee pointed out, seems to be related to the mutual captivity that emerges when neither of the parties who are in the adventure together can say “no”. The Commission points to the situation when a bank loses its power over the client because the loss, should the bank say no to further credits, is prohibitive – instead the bank clings to the hope that the client will come through successfully. In the Icelandic case it seems this image can be extended to include the Bank of Iceland and the government in mutual

162 Concluding remarks captivity hoping that matters would solve themselves. (While “risk” generates calculation, “uncertainty” will generate hope.) The same can be said about the banks of Seville, since the hope that the king would be successful in the current war and pay back his loans was unfounded. Such hopes were unrealistic since the Habsburgs were more or less constantly under pressure to defend (sometimes by conquest) their vast territories. Further, the loans to the king made the banks vulnerable to variations in the arrival of the treasure fleet from overseas. The same kind of reasoning can be applied to the Fugger case (a captive “court” bank). Its loyalty to the Habsburgs, to the extent that it jeopardized its own existence, to accommodate an insatiable demand for credit (mercenary armies), was partly the result of earlier benefits from serving the king (e.g., mining rights), but it helped only marginally as the king resorted to declaring the government bankrupt (or, rather, suspend payments) to solve the debt problem (or, rather, the cash problem). It was this lesson, together with the devastation of German soil that resulted from the 30 years’ war in the early 17th century that more or less forced Fugger to withdraw from banking. The case of Medici is rather complicated. We can see that with a firm hand (Cosimo) at the centre Medici could adapt to the changing circumstances of the underlying business (alum together with the Vatican, silk through Venice and in Lyon, and wool in Northern France). It was, truly, a merchant bank. But then the allure of courts, and royal power, drew representatives away from trade and into other business. A lack of attention from the centre and outright cheating from some offices justified the Medici withdrawal from banking. In sum the cases have illustrated the fateful interaction between the assumed rationality of decision making (by individuals or organizations – yes, I know that it is claimed that only individuals can make decisions, even if they are controlled by their desires and utilities most of the time), and power whether external or internal to banks. Power – that which allows actor A to make actor B do something that B would not have done otherwise – is by definition an irrational phenomenon. There emerge, as people organize, e.g., into social entities like a city or a business firm (Boltanski 2011; Boltanski & Thévenot 2006), codes of conduct related to membership. In such an entity, members who are able to circumvent or bend rules (without really breaking them) – those who can get things done – are usually awarded worth and promotion. If such ambitious members are promoted to positions of power and continue to act with a lack of respect for the codes of conduct, such behaviour is visible to other members and the codes themselves are undermined (corruption). Reversely, moral leadership at the centre will encourage ethical behaviour in local units, provided it is visible. To take an example, Medici under the leadership of Cosimo was visible, not least by the stress on proper book-keeping. When later generations paid increasing attention to politics, local managers pursued business opportunities that were risky or oriented toward princes (in violation of the principle: Don’t lend to princes!). Moral leadership does not mean the same as power, since power is often un-reasonable – if reason does not persuade, use power – while moral leadership builds on the ability to

Concluding remarks 163 justify. In RBS it seems like Mathewson cleared the way for it, and then Goodwin overused power at the cost of rational management (a claim that could not be proven in court). Power, quite easily becomes an irrational factor inside organizations. External power, the power to influence from the outside, is more problematic, since it takes many forms, but it seems like we have to rely on “State” (courts) to regulate the illegitimate use of power. The problem with the State, as Buchanan (1975) argued, is that it is itself subject to illegitimate use of power (self-interest, special interests). However, society cannot exist without organizations. This brings us back to the origins with Aristotle and his “free will” as the basis for rationality in society. How can the concept of organization be compatible with free will? Streeck (2017) has an interesting discussion (where he endorses a genealogic approach to the concept) of hegemonic power in his review of two books by Perry Anderson (2017a, 2017b) on the conception of hegemony from the old Greeks (Thucydides) to present day international relations. What is the relation between coercion and consent in different circumstances? The purpose of hegemonic ideology is to make believe that the hegemon is benevolent. Wherever they crop up, hegemons and their ideologues will do what they can to identify hegemony with legitimate authority: a social contract among equals in which leaders govern by consent and their followers give that consent in grateful return for services rendered. (Streeck 2017, p. 25) Hegemony (Streeck calls it “the H-word” to indicate how a word can be value-loaded) is usually thought of as belonging to the vocabulary of the radical left – true that Gramsci uses it in discussing revolutionary tactics – but Streeck (p. 26) brings up the benefits to the German economy of the European Monetary Union as an example. Germany, having voluntarily incapacitated itself militarily, was initially unwilling to take the lead in the monetary union, but has now achieved a hegemonic position, economically, in the union. This happened by, first, promoting that the allied (turned dependents) organize themselves on the model of the hegemon (Germany), and second, (if we realize that struggles for hegemony are multi-levelled), supporting the idea of the “modernizing elites” of France and Italy who saw a solution to the difficulties of competing with Germany, in a drive to force the German hard currency on “their soft societies in order to make them fit for modern capitalism” (Streeck 2017, p. 26) (eliminating devaluation as a method to compete against the strong German economy). Now, Streeck claims, Germany is working hard to reform Europe to become more like Germany (in the name of unity); hegemony in the form of “leadership” based on values, as it were. Seemingly it is losing voters to nationalist movements at home in the process. Where is the borderline between regulation by consent and by compulsion here? Once

164 Concluding remarks hegemonic power is present the border gets blurred! These are complex issues that come to mind again and again while reflecting upon the power of the financial sector, nationally and internationally. On a more practical level, we have seen in several cases that the bank under study seemed to run out of options at a certain point, thereby becoming a captive of its earlier commitments. The reverse situation, that a bank holds its immediate environment captive, is illustrated by the case of Iceland. This does, obviously, also happen in markets that are supposed to be free. Predatory capitalists, made possible by the astonishing capacity to mobilize and transport huge sums of money that information technology can muster, can take over their victims without any further merit than the ability to present financial resources at the right time. “The victims” have come “in play”, and they have little time or resources to defend themselves against take-over. It is a significant observation, I think, that modern banks seem to be quite preoccupied with defensive strategies against take-overs. That is a far cry from the optimism of the industrial revolution when ideas could attract investment – in contrast to today’s scouting/exploiting of weaknesses in Balance Sheets. “Cornering” a victim, i.e., placing it in a captive situation with no options but to accept, might have been standard practice in medieval times as well as in business of recent times. But it does not go well with a social philosophy of freedom and rule of law. The ideology of market solutions, going back to Aristotle, has been the free will/choice of competent parties. The core of legal reasoning here was, and has been since Aristotle, that a contract closed under duress, incompetence or fraud is not valid. With contracting between free individuals replaced by an idea of a market as a system that determines fair prices on the basis of “information” that is available to all, the ethical dimension seems to have been lost. With that, power, be it “market power” or other kinds, has been given free reins. This, in turn, renders financial markets inherently unstable, because “captivity” can set market irrationality in motion. When does – under what circumstances – hegemonic power turn into authority? When does coercion turn into consent? It will have to do with reason-giving rather than irrational power. It seems promising, therefore, to base further reasoning on this issue on the “Polity Model” of Boltanski & Thévenot (2006, pp. 74 ff.), which will be done in the conclusion of this chapter. We need more research into methods of balancing power inside banks as well as between banks and their environments, and we need to do these studies on the micro level, to study banks as organizations, where members have duties, power, and responsibility. 5:4:1 The role of social philosophies I have chosen to provide an account of the dominating social philosophies that articulate the good society and, thus, embed the efforts of regulation and creative dodging of proper conduct in banking at the time. This reveals that there is ideational interaction between the “centres of wisdom” and the “centres

Concluding remarks 165 of action” as creative banking practices are commented upon by the wise, which sometimes leads to condemnation (like Cosimo Medici being expelled from town), while also giving incentives to new creative solutions (like Jewish merchants using Gentile middlemen in their double contracting). Since the “centres of wisdom” are referred to for advice on the most complicated issues, they also get up-to-date information on recent innovations in banking, which renders the deliberation of the scholarly elite in a certain sense practically relevant (if not always effective). The external shock to the Spanish economy stemming from the discovery of the treasures of America (and the need to export tools and manpower to the colonies, with a related inflation) made the late scholastics in Salamanca (“The Doctors of Salamanca”) discover and becoming the first to deal with the effects of the money supply in the 16th century. Similarly, the building of an effective State bureaucracy, the insight that the exploitation of colonies was conducted best through gigantic companies with royal monopoly privileges, also provided a basis for better control of the inand outflow of resources. Mercantilism, thus became an articulation of the practice of enhanced hierarchical control by the State (rather than an economic theory). Merchant banks could now flourish provided they were well connected. (Barings had several family members in Parliament. Although the presence at court of the Fugger house could not avert the final disaster.) The British came to be the centre of the financial world because they (beside ruling the seas) realised that the large inflow of resources from the colonies must be matched by investment in manufacturing capacity (as the “Administration Consultants and Pamphleteers” (Schumpeter 1954) argued). Merchant banks, closely connected with trade as they were, were well placed to enter an era of investment banking, leaving the logistic trouble and capital tied in warehousing, to concentrate on financing projects (and the State). Barings, still a small organization, had better access to business in London than in port towns. The laissez-faire liberalism of the 19th century made those in strategic positions in the flow of goods and money very rich, but it also generated huge masses of very poor. This was not a proper version of the good society. The current order was challenged by different forms of socialism, while the emancipated bourgeoisie (McCloskey 2006, 2010, 2016) was the carrier of hope. However, socialism as a form of life (vision) with freedom from oppression, equality and fair distribution of the fruits of labour (after the revolution) was gaining adherents. The countermove from Kings and nation builders was to mobilize the masses around nationalist causes. This led to war and devastation. The liberal elite in government and academia needed to join forces to argue the case for market solutions. The post-war period was a period of re-design of societies and economies under a strong challenge from absolutist socialism. Economics had now become an academic science and the translation of scientific progress into policy recommendations required platforms for deliberation and articulation. The war of devastation had been followed by a war of

166 Concluding remarks propaganda. The Mont Pélerin Society and Libertarianism (under the direction of donators like Charles Koch) are therefore presented as background to this era of policy initiatives to build institutions (like the European Union). With the failure of the Soviet empire and the end of the Cold War – the end of history it was called – the stage was set for de-regulation as the solution to a new global world order for capital mobility and a greatly expanded finance industry. The resulting abundance of strategic options and the risk of losing control over one’s own organization opened up for predatory capitalism, every strategy having to include defence against possible take-over (“come into play”). Barings (and many other banks) succumbed to the effects of “strategic stress” as they tried to mix older principles with new ones, resulting in a lack of managerial capacity to deal with several significant strategic moves at the same time. The inhuman rate of change included new (IT) technologies which allowed capital to travel around the world in a split second, and a growing part of the trade with financial instruments came to be conducted by algorithms. The social philosophy of neo-liberalism as articulated by, e.g., the Austrian school, kept to their teachings, and demanded, with the quote from Anthony Hopwood (from memory), “In the name of THE MARKET markets must be made more MARKET-like”. We want the world to adapt to our ideas about how it should be, which by the way, is a fine idealistic wish, provided that it is a common wish of a large part of society. We are not there yet; on the contrary, divisions are deeper than in many decades, simplification of complex issues abounds and we avoid facing the really significant problems of the “integrated” world (by IT). The money supply is too big in most economies, the interest rate is close to zero (or in some cases below zero), differences are growing between the very rich and the large swaths of the population that see little progress or hope for the future. This is a time when children have little reason to believe that they will be better off than their parents. New waves of nationalism, sabre-rattling, and spin-doctor politics set the stage for disillusion among intellectuals and scholars, as well as in the population in general. Is it time for a new social philosophy to describe the good society that we should strive for together? 5:4:2 Is there a scientific approach to very large and complex problems? Charles Perrow (1984) invented the concept “normal accidents” to describe the fact that accidents in large, complex, highly integrated systems will happen just because of their complexity and integration. Even if every part and professional office holders do their job exactly according to instructions, deviations will happen and when they do they will proliferate through the system with the speed of light (literally). Compare with the fact that in the time of Medici the expected time of payment (by Bills of Exchange) to arrive in Florence from Bruges was 90 days). The “normality” of accidents stems from the fact that the systems are so strongly integrated and devoid of buffering slack (to absorb

Concluding remarks 167 shocks). Given this type of conception about the exceptional conditions we live, and manage, under today, one might wonder whether there is any reason to pay attention to the experiences of bankers 500 years ago? Can anything of value be learnt from such a practice? I believe there is, from a scientific point of view if not from a practical one (banking is so different now). However, we have to look again at what constitutes scientific statements. The proper choice on this matter is Popper’s Conjectures and Refutations (1963) where he discusses how scientific knowledge grows. His point is that the criterion for a statement being scientific is that it is testable against the real world. A hypothesis must be possible to test, that is, be falsifiable, otherwise it is not scientific. But how, then, one might ask, are we to come up with ideas about testable hypotheses? Popper’s answer is that one may use whatever method (conjectures will do) so long as the hypothesis is falsifiable. When Schumpeter points out that economists have rarely relied on professional academic psychology and preferred “home-made” assumptions that fit their models (and the related mathematics), he points to a weakness in the very basis of large parts of scientific economics. Suffice it to remind the reader that Black & Scholes’ (1973) model of option pricing is built on the same assumptions of “random walk” (that is prices move completely stochastically) as the model on the movement of molecules in gases. One might at least hesitate to accept that assumption (which undermines the falsifiability of hypotheses built on Black & Scholes (1973)) after reading Donald MacKenzie’s (2018) essay on “short selling”. Professional economists argue that short selling – selling something you do not own now for later delivery (when you believe it can be acquired at a lower price) – helps the market function better. Of course, it will! But in an efficient market there would be no opportunity for short selling because every market actor has the same information. Why worry? Since we all know that markets are not perfect we need not worry over an elegant mathematical exercise. The problem is that MacKenzie gives an account of all the tricks, like spreading rumours, to mislead “the market”. What is a rumour anyway? It is my true belief that the pound will go down, Soros said, and since he was the one who said it, his large positions on the pound turned out to yield great profit, because “everybody” (believer or not) saw it as necessary to follow suit. Long Term Capital Management (LTCM) had an excellent business strategy based on science, but since everybody copied whatever positions LTCM took, they failed. The borderline between facts and fiction in matters of finance is diffuse. Popper’s idea about falsificationism no longer holds. So, what did Popper actually mean? He discussed science and allowed virtually any method (conjecture) to generate a hypothesis, so long as it is possible to test it. Science will grow by the elimination of error. So, for Popper, even library studies of historical sources are permissible in bank management studies. Care is required, though, not to make claims about what actually did take place in the mind of Jakob Fugger or Cosimo Medici, we cannot do that because such claims are not testable. Economic historians are careful to examine, critically, documentary sources and cross check, since we all know that what is

168 Concluding remarks written in letters etc. is not always true today as it probably was not then. In that way they puzzle together an account with all the sources referred to (for the reader to check) and discuss alternative interpretations. It is a matter of having solid evidence in the form of historical documents and then drawing the logical conclusions. In social sciences one cannot always have access to historical documents (or measurements) and then much research is based on assumptions and the researcher relies on the logic of deduction (mathematical models). Then conclusions are valid – provided that the assumptions are correct. Often, we see a drift here, where, first, the assumptions are forgotten (they can always be revived in defence if conclusions turned out to be false in real circumstances (Mirowski, 2013)), and, later, it is argued that the world should be made to live up to the assumptions – because then the world would benefit from scientific knowledge. Wait a minute! What is going on here? Change the world to fit the assumptions that constitute the basis for models? Is that science or propaganda? As indicated in Figure 1.1, I have assumed that the “circumstances” of the failed banks, as well as the practices derived from their business models, do not constitute a suitable setting for measures to be confronted with general hypotheses. Facts have meaning in context, not “in general”! Instead, the “evidence” is presented in narrative form, looking for mutually supportive arguments to be sorted out as plausible explanations. Such “circumstantial evidence” is not likely to be testable in Popper’s manner, but it can be criticized and challenged by helpful readers as the essay goes through stages of development. For this we need to conduct analysis on two levels; logic, which, by definition, must be confined to the given frame of reference, and rhetoric, which aims to persuade from outside the frame of reference. This latter kind of discourse will typically appeal to values and emotional resources to promote certain goals as worthy of pursuit. In time, when adequate adaptations have been made to the frame of reference, the arguments may have been developed to a stage where falsifiability may apply and testing can be done. We are not there yet. In this case of telling stories about peculiarities of banks in comparison with many other organizations, hypotheses may be generated but hardly tested. Still there is satisfaction to be gained from the fact that I have tried to develop an alternative approach to understanding banking in its context. And, after all, Popper’s main idea is that science progresses through refutations. All that we, for the moment, consider scientific knowledge is only provisional – until it is refuted by new and better studies. The problem here seems to be that what were provisional assumptions to start with became basic truths on which theories and models were built. One such assumption was “risk”, the concept related to probability distributions, and formally only existing if we know that probability distribution. When it entered the financial markets, as modelling became a practice of the trade, it assumed its own life. Soon it was considered an obvious truth that you can only make profit by taking on risk. There emerged a large number of specified risk concepts, like “operational” risks, “market” risk, “credit” risk,

Concluding remarks 169 “liquidity” risk – the choice depending on what you are modelling. A common experience during the recent financial crisis was that historical data were not very useful in modelling what would happen after the crisis (or during the crisis for that matter). But, since we know that risk is only defined if we have the data to construct a probability distribution for different outcomes, one must wonder how “risk” came to be “reified” in financial parlance over the period of de-regulation. Detour on “risk” Markets are good things since they allow people to exchange surpluses to cover for deficits. My surplus potatoes are exchanged for your surplus of bread, and we are both better off. This is the effect of Adam Smith’s “truck and barter”. When we introduce money as an intermediary asset (and measure of value) “risk” enters the equation since you may only anticipate the price of goods as you walk from one “stand” (potatoes) on the market to the next (bread) – prices may change in the meantime. Still, money as the measurement of value carries many benefits that compensate for the risk of price changes that move differently than calculated. When we include that other actors may have interfered with prices in the meantime, things get complicated quite quickly. From a rational point of view, it might seem reasonable to assume that prices change randomly (i.e., we know nothing about the future movement of prices in the area of business we are engaging in) in order to calculate “expected” outcomes based on our historical data on price movements. Then we can justify our choices rationally (if our assumptions about the random price movements are correct then this is the best choice). Furthermore, we do not know how the other (intelligent) players in the field will act. We can assume that they follow “the rules of the game” and apply game theory, but, again, this applies if our assumption of rule-following is right – games in game theory are defined by their rules. It is easy to land in circles of assumptions in our rush to calculation. And we now have interesting arguments about why we should not disregard the benefits of rule violations in Akerlof & Shiller (2015), which suggests care with the rush to analysis. In crises, however, we only know one thing for sure – that historical data are no longer valid and, furthermore, they are of no use since the old ways have been proven not to work. At the same time, we have a distinct feeling that “risks” are increasing (and even overwhelming – existential risk), partly because we do not know what factors have generated this situation. There is no reasonable basis for modelling. The rational thing to do then is to go back to our data set and judge it for relevance and impact individually. Such inventorytaking of the micro-aspects of transactions is too time consuming to embark on in a crisis situation. To gain time in such circumstances one has to sort individual cases into categories by applying principles and using heuristics. For this to work it has to be organized in advance (and be compatible with the normal running of the business).

170 Concluding remarks An example from our current research on banks will illustrate this. In the “old days” the loss of trust in a bank’s ability to muster the necessary cash was expressed in a “bank run” (depositors queuing up to withdraw their savings). The last examples of this may have been the Northern Rock case (Liff & Wahlström, 2017) and the “Icesave” and “Kaupthing Edge” accounts in the UK (mentioned on p. 138ff ). “Nowadays” banks are chiefly funded by very short loans from other banks, and, when trust is lost, very large sums can be withdrawn very quickly, even if fair warning is sometimes given, or maybe not so “fair” as the one given by the corresponding bank to Lehman Brothers on Friday: “If you do not pay 5 billion USD by Monday morning….” (FCIC 2011, p. 333). The strategic issue under such conditions is to remain on the list of acceptable partners of other banks, because the first thing that happens in an emerging crisis is that all banks review their lists of acceptable banks to do business with (funding by overnight lending etc.) and reduce the number drastically. If many banks do this at the same time a bank can find itself without funding and there will be dire consequences. The treasurer of one of the (very successful) banks we have studied said in an interview that a lead principle for the bank is to remain on the short list of other banks when there is a crisis. In order to build the reputation to secure this, the bank must always honour its commitments (obviously), but there is also a set of other principles to support this. One such principle is that “we do not participate in syndicated loans where we would have less than full information of the contract – we must be able to do our own calculations”. Is that not the only prudent thing to do? No, in this industry – run on trust – it is quite usual to have one bank manage the client contact and the others participating on trust – the Icelandic banks earned good money on such participation for a while. Another principle in the same bank relates to this: personal responsibility. In the credit process a loan to a company will be managed by the branch in charge of the area and the “internal ranking” (part of the Basel II regulations) must be complemented by a written memo where the officer in charge justifies the “internal ranking” and recommends (personally, Moody’s credit rating can only be used as information) that the loan be granted. The loan documents are sent in to the regional office, which might ask questions of clarification. Now, if a crisis is imminent, the frequency of review of loans is increased from once a quarter to once a month. This means that the bank as a whole is up-dated on every loan in detail all the time. Loan loss can be avoided even if the process is somewhat unwieldy compared to almost automated loan management by central computer departments. Personal responsibility makes the bank able to judge each loan at short notice, and it charges every employee to sound the alarm if there are signs of weakness. These two principles, being on the short list of other banks, and personal responsibility, are normative principles dealing with what is right and wrong. They cannot be used for calculation. Given this kind of “hands-on” management principles applied to each individual loan, risk will be viewed as a multi-dimensional and context-bound judgement on 1) whether there is a risk that this client firm will meet

Concluding remarks 171 difficulties, and 2) whether this firm, given such difficulties, is able/willing to meet its obligations. This cannot be “averaged out” by portfolio management models. Here are a couple of “sayings” often met in interviews in this bank: “We have better customers” (meaning that they have been screened by somebody personally responsible), and “In all industries there are good and bad companies – we do business with the good ones” (meaning that judgement is done by case, not by industry). It seems like a case can be made for avoiding a lot of trouble (and calculation) by applying the virtue of prudence throughout the bank. One might claim that the example above is nothing but an example of classical credit management, and I would agree, but also would point out that we have seen many examples of “portfolio management” over the last decades with the use of computers for efficiency, rather than managing every credit on its own merits. Investing in “packaged” sub-prime loan portfolios is an example of recklessly aiming for a lucky bet in the face of unknown probability distributions. Because some actors did that, and since banks are so tightly knit by the funding practices that developed after de-regulation, the stage was set for “normal accidents” as described by Perrow (1984). This vulnerability comes with the close connectedness of banks for everyday funding, plus the very high leverage practiced by most banks. Banks, prior to 2008, voluntarily entered into captive positions by using extremely short-term practices of funding, encouraged by the authorities’ habit of “regulating” by flushing, when necessary, the financial markets with money. Under such circumstances the taking of high risks was profitable, and traders as well as financial advisors in “personal banking” departments could “reify” risks to the extent that they persuaded customers that risk-taking was the cause of profit. They would ask their clients about their “risk appetite” and advise accordingly. (Compare this to Cosimo Medici advising against lending to princes!) This, in turn, brings in the nature of speculation. Stout (2011) discusses three theories of speculative trading, risk hedging, information arbitrage, and disagreement models. The first one, risk hedging, posits that speculation comes about because of the traders’ attitudes toward risk. Speculators, under this view, are traders that earn profit by dealing with more risk averse (hedgers) counter-parts on relatively favourable price terms. Those counter-parts are willing to accept a lower price to avoid the risk of future price changes. A less risk averse trader does not mind taking a higher risk (or can diversify away the risk). Dealing with this counter-part provides a service by reducing risk, which can be seen as a socially desirable insurance service. This would, indeed, appear to be a very mild form of speculation. The second theory of speculative trading, information arbitrage builds on finding assets with too low a price. Grossman & Stiglitz (1980) view such speculators as having done careful research to identify mispriced assets. Since they have invested in information that is superior to that which is held by lessinformed traders, they will be able to arrive at better terms. Speculation, thus, is

172 Concluding remarks a consequence of the differences among market actors in willingness to invest in information. The implication here is that this kind of speculation will produce social benefits since assets will be correctly priced in the end, but also that such information arbitrage will add liquidity to the market even if the two traders in focus are engaged in a zero-sum game. The third approach builds on differences in judgement – there is disagreement – between two actors in the market. They both have invested the same amount of time and effort in investigating the creditworthiness of a corporation, but they have attended to different types of information, and have reached different conclusions about the likely development of the corporation they are about to invest in. One actor believes that the asset (say, a bond) will rise in price and the other that it will fall. The first actor is willing to provide the second actor with a financial paper (a CDS) that “insures” the bond against the fall in price, which the second actor is pleased to buy. As a consequence, both actors have assumed new risks. This transaction does not add to the liquidity of the market, and, because none of the two actors have superior information – they just have different information – there is no improvement in the market’s pricing of that bond. This, argues Stout (2011, p. 10), is serious because a) real people trade on disagreement (look at any investment newsletter or financial column to verify), and the argument that a person who loses will stop trading is not valid since there are new investors coming in, and b) there is no social benefit since disagreement trading (speculation) is economically inefficient as it increases risk without any offsetting social benefit. There are good reasons to suspect that derivatives trading has this effect in many cases. It is a form of betting (Stout 1995). Due to the tight connectedness in the banking industry a bet that turns out to be bad might generate a “normal accident” (ask Barings). One way of being prepared for such conditions is to set up a preparedness to switch from “normal” efficient business (with the standard probability distributions of different risks) to the extraordinary mode where information gathering is broader, and heuristics, pattern recognition and intensified local/ central communication are applied. The key, then, is to be early in recognizing that things have changed. We wrote on “semi-confusing information systems” in 1978 about a number of mechanisms that can be used for the organization to stay alert to signals of change (Hedberg & Jönsson 1978). In sum, two things need to be addressed in research to find ways for banks to be able to avoid failure when adverse conditions emerge. 1

How to avoid being trapped (becoming captive) by external encroachment or by internal preoccupations, leading to the bank running out of strategic options. There is also the other end of the scale to consider – when there are too many options – like the situation at the beginning of de-regulation. Then predatory capital was on the loose, and banks had to acquire other banks for defensive purposes, or arrange protection against take-overs in other ways. Barings was clearly in that situation and did not have the

Concluding remarks 173

2

capacity to mend control functions in time to prevent the Leeson incident. RBS seems to have suffered from a variety of the “strategic stress syndrome” by importing the predatory capital attitude to colour its leadership style at the centre. At both ends of the scale there is a “loss of control” outcome lurking, whether it be government bail-out or loss of identity in a merger integration scheme. How to deal with the realization that the nature of risk is different in “normal” and “crisis” times. Since crisis is not always a matter of failure, but can come from connectedness, the risks in the latter kind of mode must be treated on their own individual merits. This needs to be organized before the crisis. Risk, which is a concept defined in a simple world with few variables to watch, and known probability distributions to calculate, has been turned into something else in the last few decades as “modellers” have entered the scene.

What confounds the situation is the staggering increase in complexity and contradiction that has characterized banking since the middle of the 1980s. One might object that the world is always characterized by complexity and contradiction, and that it is rather a matter of how close you look at things (a cell is clearly a very complex thing), but the point is that, with Merton’s (1968) “strain theory” (also commented on by Geertz (1973)), one can expect an increased demand for ideology production in times of complexity and contradiction. This will provide opportunities for activist professions to argue/ promote their cause, by simplification of things in order to reduce the number of dimensions considered. Hereby policy options can be made calculable without disturbing “facts of life”. Such reductions will give different meanings to the “risk” concept depending on what professional perspective sets the agenda. The top management of banks must watch out for the risk of being “trapped” in the headlight of one such perspective, failing to see the risks related to other perspectives. A specific awareness is required to navigate the flow of arguments that tend to overwhelm us when things are complicated and contradictory. Then, as mentioned, there is a demand for ideology production to help practitioners judge what is relevant and factual. The point being made by Merton (1968) and, especially, Geertz (1973), is that ideological arguments differ from rational arguments in that they appeal to emotion and value, while rational arguments appeal to reason and fact (in the spirit of Popper). Without making too much of a precise distinction, one could look upon ideological arguments as normative and rational ones as instrumental. When, to refer to an example, used by Geertz (1973), of a union leader arguing that a proposed wage agreement should be rejected and calling it a “slave contract”, he does not mean that there are actual slaves around, but that the employers are lacking in respect for the value of labour. He uses the (emotional) metaphor to express a value. Now, if we call arguments under the regime of rationality logical, we can call ideological ones, rhetorical. This is how Boltanski & Thévenot (2006) as well as

174 Concluding remarks Klamer (2017) divide the types of arguments/critique in the “polity” or “spheres” respectively. The types of organizations they discuss have “logics” and “rhetorics”; one for reasoning inside an accepted frame of rationality, and the other for critique, i.e., arguments for change. Rhetoric, to be effective, needs to refer to matters/values outside the current rational frame (like individual suffering, risk of loss of control, injustice) in order to persuade. Rational arguments use logic to demonstrate that a given act achieves the best results under the given premises. The basic choice, since ancient times, is between preparing the premises to allow straight forward application of logic, or to provide critique by testing/challenging/correcting premises to create space for value-changing ideology. This latter activity is usually done by narratives (like Aristotle did, or the scholastics evoking a passage from sacred texts to underpin interpretations of what constitutes virtuous action in new situations). With this distinction between types of arguments, one easily realizes that by conceiving the market price as a result of “common estimates” by many actors pursuing self-interest, any rhetoric against the use of the market price for valuation must resort to particular cases and have a narrative build-up. The narrative can then be dismissed as atypical, or with the Pareto argument that it is all for the common good. The risks that follow from dimensions relegated to being outside the premises are, thus, not relevant when judging the logic of the market argument. The counter argument for critique of market-based logic is, to paraphrase Wildavky’s pronouncement on program budgeting: “We only have one world – procedure X has been tried in it – it did not work!” This type of argument is invalid, I am afraid, when used to counter economists applying market efficiency hypotheses of stronger or weaker kinds. They always have the caveat, as they should, that their conclusions apply only when their assumptions are fulfilled. Take as an example, Bernanke’s pronouncement at Princeton in September 2010 (Mirowski 2013, p. 188): “The recent financial crisis was more a failure of economic engineering and economic management than of what I have called economic science…”. There is always a way out to avoid critique against a theory that cannot predict – its assumptions were not fulfilled. This makes finance theory proof against direct critique (only errors of logic are acceptable reasons for critique). And the failure of financial markets to maintain a reasonable equilibrium can be said to be due to incompetent conduct of the actors depicted in the theory. If only the world could be made to behave like the theory predicts we would be safe. The problem here is that I am inclined to agree with Bernanke – the recent financial crisis, as well as earlier ones, seems to be caused by mismanagement or error of judgement by real people. The same kind of reasoning applies to the concept and modelling of “risk”, which has been made proof against critique in the same manner. For every new kind of risk that is discovered, a new metric and a new model is constructed. This has led us to focus on “risk measurement” – instead of “risk management”, which is what real bank managers should be concerned about. It seems like we have found two pertinent aspects of bank failures that should be investigated further; a) the balancing act between the Scylla of

Concluding remarks 175 becoming captive (running out of options) leading to loss of control, and the Charybdis of recognizing too many strategic options, (acting on too many dimensions in relation to managerial capacity), and b) reification/measurement of risk in ways that make the resulting risk-panorama “unactionable” for the practical banker, entombed, as it is, in abstract econometrics. In the final analysis; what prudent bank management must always keep in mind is the existential risk – the risk of losing control by abandonment. It used to happen in the “old days” by bank runs – when depositors are no longer willing to let the bank continue to “safe keep” their savings. They queue up at the gate to withdraw everything and the bank runs out of cash. In these days that same phenomenon consists of fellow banks refusing short (“over-night”) funding. The bank has lost its “good name”. Then there is no way out – the bank has lost its “capacity to cope”. In most economies there is a “lender-oflast-resort” who will deliver the “coup-de-grace” by letting the failing bank go, buy the bank, and/or flood the “market” with money. This existential risk is not a statistical phenomenon – it is 0/1 – either it is latent (a zero) or it is (deadly) present (a 1). How does the banker “observe” such a latent risk? Loss of trust is contagious, and once it starts to happen there is little the bank can do. What has to be done must be done before the crisis is manifest. It is a matter of balancing available options against coping capacity. Coping capacity, to a very great extent, hinges upon the bank’s good name. A “lender of last resort” can only buy some time during which the bank has to realize assets to satisfy the most pressing demands, but since the good name is lost in such an operation, the long battle of re-gaining a good name remains. The odds are not very good! The manifestation of existential risk can come from external sources, like when Fugger bank digs itself into a hole of dependence on the fortunes of a prince, or when a bank in Seville experiences a delay in the arrival of the El Dorado fleet. Or from internal ones, like when Medici or Barings find out (too late) that there has been internal treason (Leeson), or reckless local risk-taking (Sassetti). This is a matter for central leadership in a bank – to worry about existential risks, and infuse the bank with confidence, at the same time.

5:5 Quo Vadis? Is there a next phase? Of course, the regulatory efforts and the socio-philosophical rendering of ideas about the good society will continue and gain adherents enough to implement further rules and principles. My forecast is that the next step will consist of a constellation of “warring professions” and “identity politics” (which is a pretty pessimistic view). 5:5:1 Warring professions and identity politics A distinctive characteristic of the development of banking under the deregulation of banking since the mid-1980s is the staggering growth of the

176 Concluding remarks size, not least in the number of employees even if there are reductions at the same time due to bank technology. Part of the explanation is that growth in size is a primary defence against take-over bids. But another dimension is the remarkable growth in the use of IT in banking, not to mention the invasion of scientific modelling of various aspects of operations. “Identity politics” is, according to Webster’s dictionary: “politics in which groups of people having a particular racial, religious, ethnic, social, or cultural identity tend to promote their own specific interests or concerns without regard to the interests or concerns of any larger political group”. This is relevant for the regulation of banking as well as other policy areas. It emerged as a conception in political and social debate during the last decade of the 20th century, and it denotes a certain disregard for the common good (even if policy arguments quite often point to the fact that what is good for a particular group (e.g., the “filthy rich”) is, in the end, good for all (the “trickle down” idea debunked by Piketty (2014)). It, thus, legitimizes activism on behalf of groups (like the entrepreneurial minority in the case of Libertarians) at the expense of other groups (the “collectivist” majority). The Libertarians are a telling example of how rhetoric changes with “identity politics” without a corresponding change in the theoretical underpinnings. Instead identity politics scans theoretical schools for “scientific” arguments that fit the persuasive purpose and rewards the “useful” ones. This entails a disregard for “facts” and a promotion of opinion. In the terms used above, we get a shift from “logic” to “rhetoric”. This provides a backdrop for competition between science-based professions for influence and reward. Identity politics also widens the market for “spin doctors”, a profession specialized in filtering out the good rhetorical devices and suppressing uncomfortable facts. That is an ideologist’s work, all in service of the principal. Lawyers are in a similar situation, with “jurisprudence” or “due process” shielding against any accusations of bias. Competition between professions for influence, funds, or promotion will generate “boundary work”, including the following. a

b

c

Expansion into the territories of other professions by trying to heighten the contrast between professions (or occupations) in ways that are flattering to the ideologist’s side. Monopolization of the professional authority of the ideologist’s group by trying to exclude rivals on the current inside of the profession by defining them as “deviant” or “amateurs”. Protection of the autonomy of the professional group by exempting its members from responsibility for the consequences of their work by blaming scapegoats on the outside.(Gieryn 1983)

By such ideological arguments some professions can be expected to gain the appreciation of principals for periods of time, and then be replaced by a rival in cyclical patterns. It is a matter of rhetoric rather than the application of the scientific basis for a profession.

Concluding remarks 177 This kind of ideological competition was present also in earlier times; for example, when membership in guilds was a requirement for certification in banking. Or, when being well connected at the prince’s court, or with the Vatican, required certain qualities in the aspiring banker. It may be seen as an exaggeration to call this professional competition in the same way as Gieryn (1983) describes the competition between “scientific” and “non-scientific” professions, but it still is a matter of access to professional activities, albeit in a more practical mode. For the leaders of the Icelandic banks being well-connected to government and regulators provided a shield promoting the entry of the “new” professionals arriving from master programmes in Finance. Being “professional” about finance impressed public sector representatives, as well as media, to the extent that attention was directed to the beneficial effects on the economy at large, instead of detailed analysis of performance. The expansion of banks, and the advancement of IT-technology, increased the capacity of banks to manage information (provided it was in standardized form), by judging/calculating consequences of action in models rather than case by case. It also allowed movement of large sums of money across the globe in transactions that, increasingly, were constructed by algorithms. First there was an inflow of traders, then computer scientists, modelling experts, risk managers, compliance and legal advisors, PR experts etc. Each with a persuasive language in promotion of the approach to problems suitable to this or that profession. The traditional bank managers had to try to learn (or consider retirement). Their choice of one or the other profession as the lead one in shaping the banks efforts to meet the challenges engendered by de-regulation might be assumed to have been less well considered than it should have been. Some of the new features of the management structure were compulsory (like the requirements of Basel II), others were strongly promoted by outside consultants. Most initiatives would meet with resistance from professions that felt mistreated and arguments would increasingly be of an ideological nature resulting in a situation of “warring professions”. With the different professions seeking support from colleagues in other banks, and in the university departments, there will be developments where loyalties shifted from employer to profession. This was most visible in the profession of “traders”, driven, as they were quite early, by ideas about the beneficial effects of incentives designed into bonus systems that emphasized individual performance. This, in turn, would generate tribal patterns inside the bank with “star” performers recruiting newcomers as “errand boys” (or girls) trying to qualify for promotion by loyalty and betting on the right horse. (We often met opinions in the banks we studied about the traders looking to careers by moving to other places in the financial sector rather than promotion inside their current employer.) The same tendencies could be found among those engaged in compliance, IT, etc., all inspired by the neo-liberal ideology of individual freedom and self-interest. The common good, if anything, would refer to the status of one’s own profession. In this sense, the shift could be interpreted as a shift from “market” toward a new kind of “Community” (professional prestige, perhaps).

178 Concluding remarks STATE “Hierarchical Control”

“Theory/Debate” / Principles

“Theory/Debate”

Practices Principles

MARKET

COMMUNITY

“Dispersed competition”

“Spontaneous Solidarity” ?

“Waring professions”

Figure 5.3 Quo Vadis? – toward a new kind of Community

5:5:2 The proper role of banks in society Having looked back on a few failed banks over the last 500 years and tried to put their particular activity in their particular context of philosophies of the good society and of emerging banking practices, one might wonder if there is anything to learn to avoid such calamities in the future. One can say with some certainty that the banks of olden times were comparatively small (Medici and Fugger were powerful, though), and their demise was not a catastrophe for society at large, but today’s banks with their size and with the easy movement of large sums of money in micro-seconds, there definitely is a legitimate interest for society to worry about what banks are doing behind the glassy facades. There is a considerable moment of gambling in high finance (MacKenzie 2006, 2009), and we can also see that an increasingly important part of the oversight work done by, for example, the Federal Reserve is to stop trading on individual financial papers to allow the “machines/algorithms” that do the trading to be reset and the “mini-crash” halted. What was earlier the mysterious genius of gifted traders is now the speed of reaction to price changes built into computer systems. A new kind of profession, the “léger-de-main” (sleight of hand) of IT experts is giving competitive advantages to banks (Lewis 2015). But, the advantages for some of a new agility in finance dealings carries with it the “downside” that internet-based fraud is becoming a monster that is difficult to

Concluding remarks 179 combat by the security departments of banks. The security people have the professional disadvantage that they must always count on the villains to be creative and not following rules, i.e., they are unpredictable. Therefore, the fraudsters are not easily susceptible to scientific modelling, at least so long as they remain creative. Undeniably, from a human perspective, banks have become much larger organizations with a larger impact on society (and States) than ever, IT-technology has reduced transaction time and thereby reaction time (for humans), and there is a new “science” to tell practitioners what realities they are dealing with (reification of finance theory). These are good reasons for trying to specify what kind of requirements bank should live up to if their duty were to contribute to a good society. In a good society I posit (with Boltanski & Thévenot (2006) and Klamer (2017)) that individuals are engaged in “valorization”. But what is “valorization”? One has to respond by example: I may buy a sirloin steak at the butcher’s at a certain price/kg, but the value of it is created when I cook it and enjoy the meal, and a stimulating conversation, with friends. My house may have a market value but it is primarily a home that I try to keep cosy and enjoyable to my family and those guests who come to enjoy a meal. The difference between the house and the home has been achieved by “valorization”. The particular character of valorization, Klamer (2017) claims, is that most worth that is generated by that process is “shared goods”. The enjoyment of the meal is embedded in the stimulating conversation, and in seeing Barbara and Rolf again – it is shared because I would be sad if I saw that they did not enjoy it as I did. This brings us to organizations. We usually think of them as “coalitions of individuals” as March & Simon (1958) did, for a certain purpose. I think there is more to it than that. Organizations are, in real life, “legal persons” that can be prosecuted and sued for damages. In theories of finance, banks are “decision makers” (e.g., individuals) in a market where they optimize a goal function, subject to risk appetite and other constraints. All the “valorization” issues have been pushed aside. In order to clear away all manner of unnecessary assumptions about the character of organizations and individuals I chose to start from a generic model, “the Polity Model” by Boltanski & Thévenot (2006, pp. 74 ff.), and then fill that model with “logic” and “rhetoric” suitable for the future bank in a good society. I will come to the meaning of “logic” and “rhetoric” in a minute. The Polity Model is built by six axioms, that Boltanski & Thévenot give “life” by inserting specified logics and rhetoric to constitute, e.g., “civic” or “industrial” societies. (Note the affinity with the social orders of Streek & Schmitter (1985).) The axioms are: 1 2

“Common humanity” – a set of persons capable of reaching agreements – “members” A principle of differentiation – that allows at least two states for members, which in turn allows justification of action and tests of the attributes of states.

180 Concluding remarks 3

4 5

6

A principle of dignity – allowing all members “identical power of access to all the states” which sets the stage for agreements (in a multistate polity) and for disputes to be handled according to agreed procedures A principle of ordering of states – which is necessary to coordinate action and justify distribution, expressed in a scale of values. An investment formula – in order to explain why not all members are in the supreme state of happiness we need an investment formula that links a higher state to a sacrifice or cost required for access to it. A principle of common good – we need such a principle to note how movement to higher states is beneficial to the polity as a whole. Only then can we speak of an order of worth (merit).

Boltanski & Thévenot (2006, pp. 78f.) test this model of axioms by attempting to generate a market order from the six axioms. Axiom 1 applies since people in a market economy cannot be exchanged, like goods. What about the slave trade, mentioned in the case of the Sevillian banks, one might ask? The answer is that we are talking about the individuality of the actors – the members – that constitute the market. Differentiation (axiom 2) is expressed in the wealth of the actors (purchasing power as it were), and axiom 3 is about the opportunity of becoming wealthy, axiom 4 states that access to all states is assured by free competition. The ordering of states is unproblematic since the measure naturally is wealth. The investment formula (axiom 5) translates into opportunism as all actors seek business opportunities all the time. The last axiom (6) about common good is the most difficult to fulfil even if Smith (1776) produced a most polished formulation in “the invisible hand”, which guides the trade activities toward a higher common good. I will come back to this issue. From axioms to principles These axioms are quite abstract and, even when Boltanski & Thévenot (2006) apply them to form a model of the market economy (as a polity) they are still quite abstract. However, we should take note of their approach to the application: they construct plausible principles to show that their polity model is valid. This is a key instrument in approaching the world of action and ethics in action – ethics that maintain the polity/organization and encourage members to continue their membership. Such principles typically link two or more axioms to one another, and serve as normative and instrumental guidelines for organizational action: normative about what one should do, instrumental about how one should do it. They also link the judgement of others to that of our own (by procedures like Smith’s (1759) “impartial observer”). By being observant of how others might judge our action we commit ourselves to “live up to our role” in the community (be it a bank or society at large). This will to comply with role expectations (i.e., to membership) gives the principles their normative power (Korsgaard 1996). Joint application of a set of principles makes the members’ organization efficient by division of labour and central

Concluding remarks 181 coordination (more efficient than markets one would assume, since there are so many more organizations in the world than markets – a simple application of Darwn’s principles (variety, selection, retention) gives reason to assume that there is some survival capacity in organizations after all. Now, the selection of principles to live by is a matter of alignment with context. The principles must be reasonably understood to “work” in the given context. Persuasion of members that this is the case is ideological in the sense that it refers to values that are accepted or acceptable to members. Again, logic is reasoning inside a framework given certain values, rhetoric is referring to values outside the framework that ought to be brought into it for consideration (values like justice, suffering, love, hope, faith). Therefore, it is rhetoric that comes to use when arguments for change of principles are the topic. Such arguments appear in times of crisis. Why, then, should a bank change its principles of operation or management? The first pre-requisite is the presence of critique, which serves to engender emancipation from the entrapment in the routines of “normal” operations (more of the same) that banks and other organizations tend to prefer. This brings us to Boltanski’s (2011) discussion of tests. In Chapter 4 he distinguishes between a “practical” register of action with low level of reflexivity (business as usual) with a certain tolerance for differences, and two metapragmatic registers (confirmation and critique) with high levels of reflexivity. The possibility of critique emerges on the metapragmatic level from two kinds of contradictions; the first has to do with the foundations of the institutions (their legitimacy) and the capability of the spokesperson for the institution to live up to that role (representing the foundations in action). The contradiction here is between the confidence in the institution and the realization that the institution in itself is a fiction (set of beliefs) with a spokesperson of flesh and blood, with the usual weaknesses – a hermeneutic contradiction. The other contradiction is semantic/pragmatic in the sense that it emerges when there is a discrepancy between “words” and “deeds”. If these two discrepancies are present there is a need for reform, sometimes radical reform. Boltanski (2011) argues that we use different kinds of tests to establish an arena for critique – critique being the required premise for change. To set the stage for these tests we need to distinguish between “reality” and the “world”. We are immersed in the world with all its variety and complexity, and we will never be able to fathom its entirety. In order to be able to act in the world we construct “reality” by extracting from the world elements that we order by test formats, qualifications, principles of categorization (Boltanski 2011, pp. 90 ff.), and deontic power that generate prescriptions and prohibitions. The main business of life is conducted by aligning forms of behaviour by the rules that constitute the power of institutions, and institutions confirm and re-confirm relationships between symbolic forms (words) and states-of-affairs. “Reality” is what we can understand and manage with our concepts, principles, theories and logic – the “world” is everything out there not yet categorized and conceptualized, and therefore unanalysable.

182 Concluding remarks Against this background we can understand a truth test as a request for confirmation – Is this really a case of phenomenon A that requires treatment B? Confirmation serves to maintain the institution by repetition/routine, and, as such, serves efficiency in normal times – hierarchical control in action – at the limit the spokesperson for the institution may open up for dialogue as part of the institution’s continuous adaption to a changing context. Such adaptation is driven by a desire to find and maintain cohesion and closure. As soon as there is a gap between “reality” (the situation according to our present world view), and the “world” as it is, there is occasion for critique – the application of meta-pragmatic registers. This is done by reality tests (which are for reformists) or existential tests (which are for radicals). Reality tests compare what should be with what is and make claims as to explanations to why things could go better, for instance by claiming that member B has abilities and capabilities that are not properly taken advantage of in her current position. Changes are required to achieve what ought to be. In this sense reality tests are different from truth tests in that the reality test can either result in confirmation (the claims of the reformists are not valid) or in critique (the claims are valid and change would be beneficial). Reformists are driven by hope (see Brunsson (2006) for a discussion of hope and rationality in organizations), a “warm” virtue according to McCloskey (2006), and the reality test produces evidence to justify the hope of improvement. The critique of status quo calls for change. A well-organized bank will have institutionalized procedures for encouraging and dealing with reality tests (e.g., by starting a dialogue where the principal listens and ritual is discarded). Existential tests go outside established procedures in order to claim that offensive/damaging factors, which have hitherto been unacknowledged, should be taken into account. They may be seen as balancing on the fringe of that which has been “reality” (and the frame), and, as such, will lack concepts for description. Essential tests are therefore based on experience of affect – injustice, humiliation, suffering – and come in the narrative form. At first such claims will therefore be brushed aside as “subjective”. But at the same time as these complaints are “unconventional” they also provide a potential bridge between reality and the world. When the critique is recognized as valid the institution also recognizes that the institutional reality is incomplete, and undertakes to include the newly recognized factor in regular processes. The person sounding the alarm – when the alarm is seen as justified – will be recognized for her heroic act, while the person sounding an unjustified alarm will lose in standing (in the short run). In sum: we have three kinds of tests as a basis for critique that may initiate change in adaption to changing circumstances: The truth test that serves to confirm the current pragmatic register by showing how it works in a given situation. Reality tests that compare what is with what should be according to doctrine. This comparison may result in confirmation or critique depending on whether the claim is judged valid or not.

Concluding remarks 183 Existential tests that challenge the current frame by claiming that an essential factor has not been recognized and that this causes affect (frustration) in members and, thus, bridges to the world not yet accommodated as “reality”. For banks having a particular relational link to their customers, this escalation of severity in tests is essential. It will be the latter one, the essential test that initiates a crisis as members realize that the current practical register of action is inadequate. They therefore need a specific combination of sensitive local outreach to customers, good communication capacity to the centre, and an ability to muster joint resources to counteract imminent disasters. (Normal banking business, as Salvador’s respondent argued, is “boring”; it is when you try to make it more “fun” that risks escalate.) The chief difference between escalating risks 500 years ago and now is that now it happens very quickly. Illustrations When Cosimo of Medici pronounced the principle that “we do not lend money to Princes” it was an expression of the experience that princes tend to want more rather than repay their loans, or, if they lose the war, they are unable to repay. In order to maintain control of the firm (which was important for a family business like Medici’s), we should stick to trade and the financing of trade. From this follow many other principles that could, together, be interpreted as the business model of the firm. Cosimo could uphold this principle, with the help of his trusted and competent co-manager Benci (Soll 2014, p. 37) by way of the bookkeeping and audit tools. But when Cosimo’s grandson, Lorenzo (“the Magnificent”) oriented his interests outside the business and invited Sassetti to return to Florence from the Geneva branch, to become the co-manager of the Medici bank, he soon became enchanted by social/cultural life there and neglected book-keeping (and auditing). The branches started to take risks by lending to princes and the bank went into decline. There was nobody to assume responsibility for truth tests or reality tests (never mind that Boltanski (2011) looks upon these as tests from the bottom-up). When modern banks, in the upsurge to the financial crisis, were quite preoccupied with the risk of being taken over by predatory capitalists in the deregulated financial world – “coming into play” – it was a very real threat, especially if the bank in question was doing well. The strategy to prevent this was, ironically, acquisitions to become too big a bite for the others. The only way to accomplish this was to use the bank’s leverage (increase debt), which, in turn, makes the bank vulnerable to down-turns in revenue due to the slimmed margin. This will provide a strong incentive to invent and sell new “products”, and to diversify, making the management problem more complex, since new professions may have their loyalties elsewhere, like the “rocket scientists” (who know they are right (given the assumptions of the model)), or incentivized traders (who will take undue risks in order to improve their pay check, and look good in the eyes of fellow professionals). This kind of situation requires a

184 Concluding remarks central figure (like Cosimo) to initiate the tests that, in turn, will provide a priority among values/principles to aid the bank as an organization to arrive at concerted action to stave off emerging problems. Fred Goodwin of RBS was such a figure, but he knew best and would not allow dialogue that could hear other voices. The RBS declined into reckless acquisitions. The accounting system could not help since Goodwin had decided against installing the NatWest integrated system that would have provided an audit trail. The problem with the articulation of organizational (polity) principles is that it requires an internal dialogue between points of view. This dialogue is constantly “invaded” by external forces stemming from philosophies about the good society as well as emerging new practices (consultants). The value of membership of organizations, so decisive in older times when Community dominated the social order, is shifting. The State used to offer some comfort in that it introduced the rule-of-law as a procedure to solve conflicts, but, with de-regulation Market re-introduced the idea of the individual as the goal in itself, providing arguments to justify selfish behaviour also inside the organization. Status in the profession may then override membership in organizations. McCloskey (2016), a Mont Pélerin Society member, argues that everybody has a better life now due to economic growth over the last couple of hundred years, and that things are improving faster now than they used to. Fair enough, but that is when we measure income per capita in a conventional way. The “common good” is an argument for tyrants as well as liberal marketers. Dialogue is about listening to the other point of view and this brings in moral/ ethical judgement, like it or not.

5:6 The problem with banks – again Current consultancy jargon includes tomes about “value-based management” (Koller 1994), but this refers to members of an organization living up to values imposed by the top of the organization. Such imposed values are not really values, but commands. Underlings lack the free will that already Aristoteles based his idea about fair contract on. (Yes, they can quit if they don’t like it, but that does not sound like the core of “value-based-management”.) When a value has been accepted as the individual’s own, i.e., integrated into the individual’s identity (This is who I am! The Treasurer of this bank!) then it has become a value in Klamer’s (2017) sense – something worth striving for. There are two values that are self-evidently worth striving for: A Good Life, and a Good Society. The other values are intellectually challenging, and the multitude of values that we have with us need to be sorted out in context (Wilson 1997). I know that I can be a good father, a good husband, and a good teacher, but the values and related action have to be ordered in context. As a professor in class it will not do to crawl on the floor like one would do playing with grandchildren.. Adam Smith (1759) advises us to use the “impartial spectator” procedure and ask ourselves “What would an impartial spectator think about what I am about to do?” Klamer (2017) asks “What is important to me?” or

Concluding remarks 185 “What is important to you?” He tells a story about a study asking very old people that question “What is important to you?” The answers were usually “selfcontrol” (being in control of oneself – not living like a “vegetable”), and “giving some of my experience/knowledge to coming generations”. (Imagine how frustrating it is to be treated like a “vegetable” by a nurse or a relative when you are not – and when you are offering sound advice.) Value-based management uses “sympathy” (much discussed by Adam Smith 1759), i.e., the specific human capacity to view things from the other’s perspective. Only then can we serve as constructive partners in society. Only then can we do what is expected of us – live up to our identity. Apply this to a bank! A large amount of communication (dialogue) is required for every member to know what is expected of them – their identity while at work; their personal responsibilities. I claim that the core operation of a bank is its credit process, whereby representatives of the bank try to determine whether a prospective client is creditworthy. If the client is creditworthy, then the bank is willing to participate as part-financer of the client’s (the entrepreneur’s) “valorization” project. This might require extensive communication with the client and inquiry into the likelihood of success under different scenarios, and with judgement of the character of clients (will they apply their best effort, will they keep contracts?). Being partner in entrepreneurship requires moral judgement – there is no escape from this. The problem with this is that it requires judgement case-by-case; this is incompatible with standard risk measurement, which is built on classification of cases into broad categories based on a few standard parameters. On the other hand, it enhances risk management since the risk must always be handled case-bycase, client by client. Of course, there are mass credits that need to be managed in a standardized way (by computer) today, due to the large number of transactions. But, in both cases, there needs to be proper accounting, and internal audit, for the top management to be able to assess the situation at large in relation to context. At the centre, judgement cannot be done case-by-case in the first instance, but must be guided by principles (business model dimensions) to note deviations that will deserve attention and inquiry into the details of particular cases. Since the local credit manager is personally responsible for the initial recommendation to grant the credit, that manager will also be keen to follow-up on how the entrepreneur’s project is proceeding. The interest from the bank will remind entrepreneurs that there are partners taking an interest in their efforts and results. A moral bond from the top of the bank to the entrepreneur increases the chance that the project will contribute to the good society. (Both parties making a profit? So much the better! They will want to be partners again!) This quite conventional view of the core of banking can be summarized in a few principles: 

Banks should be more concerned with risk management than with risk measurement. Risk measurement can only be done against a (constructed) background of a model built on a few variables, and as such it can serve a

186 Concluding remarks





signalling function (something is not right). Risk management, on the other hand, can only be done case-by-case. The two are, consequently, incompatible. One must be subordinated to the other. Risk management should be the main concern for bank managers. Case-by-case treatment of credits requires a capacity that is not present at the centre, so it must be delegated to local branches. For this to function in a coordinated fashion, principles of judgement have to be communicated in dialogue. Only when the principles have been adopted as identityforming for the individual member do they have the normative power they require (Korsgaard 1996). Banks would be better off as a collective if their accounting was oriented to facts rather than hope. As may have been visible throughout this text it was the economists and their assumption that people act on their hopes for the future rather than on the facts of the present that changed things. It might be a good thing that entrepreneurs are driven by their hopes for a good outcome of their project, but they might be helped by somebody telling them that the outcome is at the end of the project, and the present process has to be managed here and now until the end is reached. Let the entrepreneur have hope, but let the banker have prudence. This translates, as far as accounting goes, to accounting for facts, which means historical cost accounting. The profit is not there until it has been realized and up to that moment the value of the project should be accounted for at historical cost, what has in fact been invested in it. The hopes for the future are a necessary good, the prudence of keeping actual facts straight is also a necessary good. This is what banks should do. This is a lesson learned from six cases of bank failures!

References Akerlof, GeorgeA. & Robert J. Shiller (2015) Phishing for Phools: The Economics of Manipulation and Deception. Princeton, NJ: Princeton University Press Anderson, Perry (2017a) The H-word: The Peripeteia of Hegemony. London: Verso Anderson, Perry (2017b) The Antinomies of Antonio Gramsci. London: Verso Berle, Adolf & Gardiner Means (1932) The Modern Corporation and Private Property. New Brunswick: Transaction Publishers Black, Fischer & Myron Scholes (1973) The Pricing of Options and Corporate Liabilities. Journal of Political Economy, 81(3): 637–654 Boltanski, Luc (2011) On Critique: A Sociology of Emancipation. Cambridge: Polity Press, orig. 2009. Boltanski, Luc & Laurent Thévenot (2006) On Justification: Economics of Worth. Princeton, NJ: Princeton University Press Brunsson, Nils (2006) Mechanisms of Hope: Maintaining the Dream of the Rational Organization. Copenhagen Business School Press Buchanan, James G. (1975) Limits to Liberty: Between Anarchy and Leviathan. Chicago: Chicago University Press

Concluding remarks 187 Chandler, Alfred D., Jr. (1962) Strategy and Structure: Chapters in the History of the American Industrial Enterprise. Cambridge, MA: MIT Press Chandler, Alfred D., Jr. (1977) The Visible Hand, Cambridge, MA and London: The Belknap Press of Harvard University Press Czerny, Philip G. (2008) Embedding Neoliberalism: The Evolution of a Hegemonic Paradigm. Journal of International Trade and Diplomacy2(Spring): 1–46 FCIC (Financial Crisis Inquiry Commission) (2011) The Financial Crisis Inquiry Report. New York: Public Affairs Financial Times (September 20, 2018) Who Went to Jail for their Role in the Financial Crisis? (Reported by Laura Noonan, Cale Tilford, Richard Milne, Ian Mount and Peter Wise) Geertz, Clifford, (1973) The Interpretation of Cultures: Selected Essays. New York: Basic Books Gieryn, Thomas F., (1983) Boundary-Work and the Demarcation of Science from Non-science: Strains and Interests in Professional Ideologies of Science. American Sociological Review 48(6): 781–795 Greenfield, Liah, (2001) The Spirit of Capitalism: Nationalism and Economic Growth. Cambridge, MA: Harvard University Press Grossman, Sanford J. & Joseph E. Stiglitz (1980) On the Impossibility of Informationally Efficient Markets. American Economic Review 70(3): 393–408 Jensen, Michael C. & William H. Meckling (1976) Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure. Journal of Financial Economics, 3/4: 305–360 Hedberg, Bo & Sten Jönsson (1977) Strategy Formulation as a Discontinuous Process. International Studies of Management & Organization, VII(2): 88–109 (Guest editor Henry Mintzberg) Hedberg, Bo & Sten Jönsson (1978) Designing Semi-confusing Information Systems for Organizations in Changing Environments. Accounting, Organizations and Society, 3: 47–64 Hirschleifer, Jack (1977) The Theory of Speculation under Alternative Regimes of Market. Journal of Finance, 32(4): 975–999 Jönsson, Sten, Rolf A. Lundin & Lennart Sjöberg (1977) Frustration in Decision Processes: A Tentative Frame of Reference. International Studies of Management & Organization, VII(3–4): 6–19 (Guest editor Henry Mintzberg) Jönsson, Sten & Lundin, Rolf A. (1977) Myths and Wishful Thinking as Management Tools. In Prescriptive Models of Organizations. C. Nystrom & W. Starbuck (eds.), TIMS Studies in Management Sciences. Volume 5 (pp. 157–170) King, Mervyn (2016) The End of Alchemy: Money, Banking and the Future of the Global Economy. London: Norton Klamer, Arjo (2017) Doing the Right Thing: A Value Based Economy. London: Ubiquity Press Koller, Timothy (1994) What is Value-based Management? McKinsey Quarterly, August Korsgaard, Christine (1996) The Sources of Normativity. Cambridge: Cambridge University Press Lewis, Michael (2015) Flash Boys: A Wall Street Revolution. New York: Norton Liff, Roy & Gunnar Wahlström (2017) Failed Crisis Communication: The Northern Rock Bank Case. Accounting, Auditing & Accountability Journal, 31(1): 237–260 MacKenzie, Donald A. (2006) An Engine, not a Camera: How Financial Models Shape Markets. Cambridge, MA: MIT Press

188 Concluding remarks MacKenzie, Donald (2009) Material Markets: How Economic Agents are Constructed. Oxford: Oxford University Press MacKenzie, Donald (2018) How to Solve the Puzzle. London Review of Books, 40(7): 11–12 March, James G. & Herbert A. Simon (1958) Organizations. New York: Wiley McCloskey, Deirdre N. (2006) Bourgeois Virtues: Ethics for an Age of Commerce. Chicago: Chicago University Press McCloskey, Deirdre N. (2010) Bourgeois Dignity: Why Economics Can’t Explain the Modern World. Chicago: University of Chicago Press McCloskey, Deidre N. (2016) Bourgeois Equality: How Ideas, not Capital or Institutions Enriched the World. Chicago: Chicago University Press Merton, Robert K. (1968) Social Theory and Social Structure. New York: Free Press, orig. 1949 Milgrom, Paul & Stokey, Nancy (1982) Information, Trade, and Common Knowledge. Journal of Economic Theory, 26: 17–27 Mirowski, Philip (2013) Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Crisis. London: Verso Mundy, Julia (2010) Creating Tensions through a Balanced Use of Management Control Systems. Accounting, Organizations and Society, 35: 499–523 Perman, Ray (2013) HUBRIS: How HBOS Wrecked the Best Bank in Britain. Edinburgh: Birlinn Perrow, Charles (1984) Normal Accidents: Living with High Risk Technologies. New York: Basic Books Piketty, Thomas (2014) Capital in the Twenty-First Century. Cambridge, MA: Harvard University Press Popper, Karl R. (1963) Conjectures and Refutations: The Growth of Scientific Knowledge. London: Routledge Previts, G.J. & R. Bricker (1994) Fact and Theory in Accounting History: Presentmindedness and Capital Market Research. Contemporary Accounting Research, 10(2): 625–641 Schumpeter, Joseph (1954) The History of Economic Analysis. London: Allen & Unwin Smith, Adam (1759) The Theory of Moral Sentiments. Edinburgh: Millar Smith, Adam (1776) An Inquiry into the Nature and Causes of the Wealth of Nations. London: Strahan & Cadell Soll, Jacob (2014) The Reckoning: Financial Accountability and the Rise and Fall of Nations. New York, NY: Basic Books Stout, Lynn A., (1995) Betting the Bank: How Derivatives Trading Under Conditions of Uncertainty Can Increase Risks and Erode Returns in Financial Markets. Cornell Law Faculty Publications. Paper 445 Stout, Lynn A. (2011) Risk, Speculation, and OTC Derivatives: An Inaugural Essay for Convivium. Accounting, Economics, and Law, 1: 1–13 Streeck, Wolfgang & Philip C. Schmitter (eds) (1985) Private Interest Government: Beyond Market and State. Beverly Hills: Sage Streeck, Wolfgang (2017) You Need a Gun. London Review of Books, 39,(24): 25–26 Wilson, James Q. (1997) The Moral Sense. New York: Free Press

Index

activist profession, 173 Albizzi, Rinaldo degli, 39 ABN AMRO, 87, 126–7, 152, 160 Academia in Anarchy, 112 acceptance books, 83 afterlife, 20 agency theory, 101, 129–30, 150, 159 Akerlof, George A., 169 alcabala, 53 alternative cost concept, 32 altruism, 102 Anglo-Irish bank, 118 analytical philosophy, 95 Antonino of Florence, 30 Antwerp Bourse, 43 Antwerp money market, 46 Aquinas, Thomas, 29, 30 arbitristas, 53–54 Asiento, 43 audit trail, 184 Augsburg Mint, 45 Augustine, St., 21 Austrian economics, 17, 99, 159 Averroes, 48 Averroeists, 49 Azpilcueta, Martin de, 52, 72 back office functions, 87 balance of trade, 71; discourse, 70 Bank of China, 126 Bank of Credit and Commerce International (BCCI), 122 Bank of England, 79, 80, 81, 148 Bank of Italy, 74 Bank of Scotland (BOS), 161 Bank of United States, 106 bank run(s), 4, 77, 170 bank crises, 9 Banks, Eric, 15, 79

Banque Commercial pour l’Europe du Nord, 82 Barclays, 122, 126–7 Barings Bank, 13, 79, 82, 148, 154 Baring Securities, 85, 86 Basel II rules, 135 Baugur Group hf, 140 Bernadino of Siena, 49 Bernanke, Ben, 174 Bernardo de Ulloa, 54 “Big 5” banks, 81 Bills of Exchange, 32, 35–7 Birmingham Midshires, 122 “Black Monday”, 120 Boltanski, Luc, 6; and Thévenot 164, 179 boundary work, 176 bourgeois dignity, 73 British Virgin Islands, 139 broker, 85, 86 Buchanan, James, 109, 110–18, 150, 163 bullionism, 36 Búnaðarbanki, 132–3 Burdian, John of Paris, 50 Burns, Arthur, 103 business model, 8, 33–5, 133, 141–2, 153–4 Byrd, Harry, 110 Böhm-Bawerk, Eugen, 27, 31 Caja de Depositos, 31 Cajetan of Bologna, 50 calculative problem, 99 Calculus of Consent, The, 111 cambio secco, 36 capitalism, 99 captive “court” bank, 162 captive positions, 171 Carmona, Salvador, 14, 50 catasto, 37

190 Index Cato Institute, 114 census contract, 42 Centre for the Study of Public Choice, 112 Central Bank of Iceland (CBI), 132 centres of learning, 24, 60 centres of wisdom, 164–5 Cerro Rico, 51 Charles V, 45 Charter of Modern Thought, 21 Charter One, 125 Cheapside, 79 Christianity, 20, 48 Citizen Financial, 125 Citizens, 121 civic duties, 49 Clydesdale Bank, 122 Coherentism, 16 Colbert, Jean-Baptiste, 22, 148 collateralized debt obligation (CDO), 127, 136 Collectivism, 99, 109 Columbus project, 121 “coming into play”, 128, 183 commission basis, 74 Committee for Social Thought, 104 Committee of Scottish Clearing Bankers (CSCB), 122 commodutum, 26 common estimate, 49, 52 common good, 177, 184 Community, 5, 21, 153, 156 Company of Scotland, 119 comparison between banks, 154 complacibilitas, 49 comprehensive financial services, 133 conditional consent, 28 consolidation of industries, 78 conspirational secrecy, 113 Constantine, 20 Constitution of Liberty, 132 Consultant Administrators and Pamphleteers, 3, 53, 165 contrapactum, 28 control at a distance, 41, 60 corporate finance, 85–6 corporate governance, 130 corporatism, 5 Corpus Juris Civilis, 25 cost/income, 134 counter intelligentsia, 113 counter reformation, 46 court banks, 54, 147 creditworthiness, 44, 83, 157

critical dualism, 101 currency exchange, 83 Cyprian, 20 damnum cessans, 29 damnum emergens, 29 Dante, Alighieri, 26 “defenestration”, 47 De Justitia et Jure, 52 De temporis venditione, 30 débirentier, 42 Decretales, 26 deficit spending, 97, 104 de-nationalization, 85 derivatives trading, 86, 172 Direct Line, 120 diversifying the measure, 30 double contract, 33 double entry book-keeping, 37 duress, incompetence or fraud, 164 duties of the State, 106 East India Company, 37, 67 Eccles, Terry, 122 economic engineering, 15 economic history, 12 economic policy, 70 economic policy production, 90 EEA Agreement, 140 effective constitution, 115 EFTA Court, 138 Egoism, 102 El Dorado, 50, 157 emerging practices, 20 Enchiridon, 21 endogeneity of money, 104 enlightened self-interest, 67 Enlightenment, 65 Enron, 121 epistemic community, 90–1, 117 equalitarianism, 111 Eurodollar, 82 European Economic Area (EEA), 132 Euroyen futures, 86 existential risk, 145 existential tests, 182 expected future income, 104 extrinsic value of money, 52 factor, 38 fair price, 1, 22, 164 falsificationism, 93, 167 federal reserve system, 106 Fisher, Irving, 27

Index 191 Financial Crisis Inquiry Report, 129 financial reports, 25 financialization, 108 Fink, Richie, 116 First Active, 124 Fish, Larry, 169 Fitch, 136 Forbes Global Businessman of the Year 2002, 125 forced loans, 42 forecasting institutes, 11 Fortis, 126 foundationalism, 16 fractional banking, 23 Francisco de Vitoria, 52 Franklin, Benjamin, 49 “Fred the Shred”, 119 free cities, 44 free will, 1, 184 Free to Choose – A Personal Statement, 105 Friedman, Milton, 5, 103 Fugger bank, 12, 43–8, 175 Fugger of the Lilies, 44 Fugger vom Reh, 44 functional view, 101 funding, 136 gambling (maisir), 24 Gemara, 23 general agent, 83 George Mason University, 3, 115, 150 Gerschenkronian “spurt”, 73 Gladstone, William, 69 Glitnir Bank hf., 131, 138 goldsmiths, 80 good name, 10, 73 good society, 179 Goodwin, Fred, 119, 122–30 government approval, 75 government bonds, 78 government failures, 110 Greenwich Capital, 123 Grice-Hutchinson, Marjorie, 13, 49, 53 Groenink, 126 Grotius, Hugo, 95 Grunderzeit, 73 guild, 147 Haas, Peter, 91 Habsburg, royal family, 43, 48 Halifax and Bank of Scotland (HBOS), 118, 161 Hambroe, 83 Hansa League, 38

Hayek, Friedrich von, 97, 149 Hebrew texts, 23 Heckscher, Eli, 15 hegemonic power, 163 Heritable Bank (London), 137 Heritage Foundation, 90, 115 hermeneutic contradiction, 181 hidalgos, 53 hierarchical control, 165, 182 historical cost, 11 historicism, 93 hiyal, 25 Hobbes, Thomas, 46 holding gains, 108 holy texts, 20, 48 Hongkong and Shanghai Banking Corporation (HSBC), 119 hope, 182 House Financing Fund (HFF), 134 HQ bank, 118 Hutcheson, Francis, 30 Ibn Asim, 25 Icelandic banks, 130, 152, 154 ideational interaction, 164 identity, 22, 30, 36, 53, 88, 184, 186; politics, 175 ideology production, 173 ignorance, fraud and duress, 45 impartial observer, 64, 67, 180 incentivized traders, 183 Individualism, 102 Industrial development, 72–3 industrial groups, 110 ING, 126 Institute for Humane Studies, 114 institutions, 102, 181 instrumental principles, 180 intentionality, 34 interest rate guarantee, 138 interest theory, 27, 32 intermediaries, 83 internal credit rating, 34 international trade, 83, 87 interventionist State, 105 investment bank, 165 investment opportunities, 27 invisible hand, 106 Islam, 23 iudicatum, 28 Japanese warrants, 86 Jesuit mission, 46 Jewish texts, 23–4

192 Index jobber, 80, 85, 86 joint stock banks, 81 joint stock form, 85, 86 Judaism, 23 juros, 43 just price, 52 justified true belief, 16 Justinian, 25 J21 (journey to one), 124 Kaupthing, 13, 131, 132–7 Kaupthing Edge, 136 Keynes, John M., 97 Killop, Tom, 127 Kindleberger, Charles P., 9 Knight, Frank, 149 Klamer, Arjo, 7, 179 Koch, Charles, 112, 116 labour unions, 107 laissez-faire doctrine, 70 land-reform, 75 Landsbanki, 131, 137–8 Landsbanki Icesave, 138, 141 Langholm, Odd, 13, 27–32 language games, 4 LaSalle Bank, 126 Leeson, Nick, 86, 149 LEP (Leadership Excellence Profile), 124 letters of credit, 83 Levant, 26, 39 Liberalism, 91 Libertarianism, 2, 109–18 LIBOR, 82 lijfrenten, 42 Limits to Liberty, 114 linguistic turn, 94 lived experience, 34 livestock, 75 Lizarrazas, Domingo de, 56–7 Locke, John, 95 loyalty, 177 Lloyds, 80, 162 log-rolling, 112 logic, 168, 173, 176, 181 Logic of Collective Action, 139 Logical empiricism, 96 Lombards, 80 Lombard Street, 147 London School of Economics (LSE), 97 Long Term Capital Management, 167 Louisiana Bank Act 1842, 77 Louisiana Purchase, 83, 148

Loyola, Ignatius, 46 Lugo, Juan de, 52 Luke VI:35, 25 Lyon branch, 62 Machiavelli, Bernardo, 39 MacKenzie, Donald, 167 MacLean, Nancy, 109 Madoff’s Ponzi scheme, 127 maggiori, 38, 39 Magnusson, Lars, 15 Maimonides, 24 Malynes, Gerard de 71 management infrastructure, 140 manias, panics and crashes, 9 market, 6, 92, 156, 159, 166 market failures, 110 Marx, Karl, 31, 68 Mathewson, George, 163 Maximilian I, 45 Matsukata deflation, 76 McCloskey, Deirdre N., 11, 158 McKinsey, 121 Medici bank, 12, 35, 146, 147, 183 Meiji Restoration, 76 membership work, 34, 184 Mercado, Thomás de, 55 mercantilism, 70, 71, 148 mercantilist discourse, 72 merchant banking, 83, 165 Mergers & Acquisitions (M&A), 85 Metaphysics, 31 Mises, Ludwig von, 96 Mill, John S., 98 Mishna, 23 mixed will, 28 Modernism, 92 mohatra or barata contract, 23 Molina, Luis de, 94 money is consumed, 44 money is sterile, 44 Money-changers’ Guild, 37 money supply, 76, 104, 107 Monopolies and Merger Commission, 162 Mont Pélerin Society, 22, 91, 98, 149 Moody’s, 133, 136 moral leadership, 215 Morga, Pedro de 2, 14, 57, 59 mortgage loans, 83 mukhatara, 25 multiplier effect, 104 Mun, Thomas, 71 mutuum, 25

Index 193 naïve monism, 101 national debt, permanent, 43 Natural Law, 66–7, 101 natural rate of unemployment, 104 nature of risk, 173 nature of speculation, 171 NatWest, 122–3 neo-liberalism, 2, 91 net-based deposits, 202 New East India Company, 37 New Bond Street Asset Management (NBSAM), 137 New Deal, 143 new economic order, 93 New York City, 106 NIBC, 184 Nicomachian Ethics, 22, 49 Nogal, Alvarez, 58 non valdes, 21 “normal accidents”, 166 Normative laws, 101 normative power of reasons, 8 normative principles, 180 “Nova Reda”, 120 obolostatica, 29 Olivi, Peter, 31 Open Society and Its Enemies, The, 100–1 organizations in crisis, 155 Ortiz, Luis, 53 Overend Gurney, 81 pactum, 28 par pro pari, 71, paradox of freedom, 102 paradox of value, 49 passion, 4 Peace of Augsburg (1555), 46 Peace of Utrecht, 59 penalty payment, 51 Performance Evaluation Framework (PEF), 124 permanent national debt, 36, 43 Perrow, Charles, 166 personal responsibility, 34, 170 perverted liberalism, 110 petrodollar, 85, 88 Philosophical Empiricism, 67 Phishing for Phools, 117 Piketty, Thomas, 15, 129 Pinera, José, 155 Pinochet, 108, 114 Popper, Karl R., 93 policy debates, 99

political economics, 53 political economy, 3, 91, 99 “politics without romance”, 111 Polity Model, 164, 179 Populism, 150 “portfolio management”, 171 Portinari, Tommasso, 39 positive economics, 27 Potosi, 50 power, 215 Pragmática, 57 predatory capitalism, 166 pre-modern state, 47 principle, 65 Principles of Political Economy, 69 profit-sharing contract, 41 profit-sharing fund, 35 proper accounting, 26 property rights, 109, 151 prudence, 186 public banks, 3, 81, 85 public choice theory, 115 quantity theory of money, 52 Quran, 24 Rabobank, 125 railroads, 78, 158 railway bonds, 109 random walk, 167 raritas, 49 rationalism, 22 “reality”, 181 reality tests, 182 realization principle, 150 redemption payments, 45 refrigerium, 20 regulation, 71 Reichs-kameralismus, 71 “reification”, 117 relational banking, 72 remain on the short list, 170 rentes, 42, 50 rescue package, 84, 86, 148 responsa, 24 restructuring, 81 rhetoric, 69, 168, 173, 176, 181 riba, 24 Rights of Man, 66 risk, 48, 168, 174 risk appetite, 171 risk management, 174, 185 risk measurement, 174 Road to Serfdom, The, 98–100

194 Index Robertson, Iain, 164 Robbins, Lionel, 97 “rocket scientists”, 183 Roover, Raymond de, 13 Rossi, Lionetto de, 40 Rothschild, N.M., 83 Royal Bank of Scotland (RBS), 13, 118, 127–30, 151, 154 Royal Exchange, 80 Royal Tax Authorities, 856 rule of law, 184 rule-makers, 11 rush to analysis, 169 Samaritan’s Dilemma, 114 Santander, 121, 126 Sassetti, Francesco, 39 Scanlon, Thomas, 34 Schmalkalden war, 46 scholastics, 27, 65, 66, 146 School of Political Economy and Social Philosophy, 110 School of Salamanca, 3, 48, 49 Schmitter, Philip, 15 Schumpeter, Josef, 11, 63 Scottish Development Agency (SDA), 120 secondary market, 37, 42 semi-confusing information, 172 sense impressions, 67 Seventh Circle of Hell, 26 seven virtues, 4 Sevillian banks, 13, 147 Serbia, 75 Sforza court, 39 “shadow banks”, 150 shared goods, 236 Shiller, Robert J., 169 slave trade monopoly, 50 Smith, Adam, 63 Soto, Domingo de, 52 South Sea Company, 14, 37, 50, 66 South Sea Bubble, 50, 59 sovereign debt crises, 9 special interests, 107, 109, 111 Special Investigation Commission (SIC), 139, 153 speculation, 112, 171 Spinelli, Lorenzo, 40 spokesperson, 181 Sprachkritik, 95 Standard Chartered Bank, 119 State, 6, 156 state interventions, 81, 144

state rights, 109 stock option program, 135 Stout, Lynn A., 171 strain theory, 5 strategic options, 85 Strategic Stress Syndrome, 88, 142, 159, 173 Streeck, Wolfgang, 2 Streeck & Schmitter, 5, 12, 153 stress test, 137 Subsidio and Excusado, 58 suftaja, 25 Sutherland, Peter, 125 Swedish tax revolt, 107 sympathy, 185 syndicated loan, 84 systemic risk, 136 Talmud, 23–4 tax revenue fund, 42 Theory of Money and Credit, 96 Theory of Moral Sentiments, 3, 64 Tingvallir, 131 tooled knowledge, 65 totalitarianism, 99 toxic assets, 126 trade agreement, 76 tricks of the trade, 32–3 truth test, 182 Tuhfa, 25 Tyrol silver mines, 45 Ulloa, Bernardo de, 54 Ulster Bank, 124 underwriters, 83 unified science, 95 use value, 30 usufruct income, 42 usury, 52, 146 Utilitarianism, 69 utility, 68 Uztariz, Jeronomo de, 54 valde boni (altogether good), 21 valde mali (altogether bad), 21 validity of contracts, 23 valorization, 7, 179 value-based management, 184 value gain, 108 vellon, 53 Vienna circle, 94, 96 virtues, 73 virtuoitas, 49 Vitoria, Francisco de, 52

Index 195 Volcker Fund, 110 voluntary exchange, 105 voucher system, 106 Walpole, Robert, 22, 148 warring professions, 175–7 Washington Mutual, 118 Welfare State, 106

will to control, 71 Wisselbank van Amsterdam, 36 Witt, Johan de, 22 Wittgenstein, Ludwig von, 94 “world”, 181 zaibatsu, 76–7 zero interest, 32